Cutting Interest rates Sooner than Expected Could Hurt Central Banks’ Credibility

Introduction

After rapid increases in central bank policy rates across advanced countries, central banks are now allowing interest rates to act and operate across the economy to slow the pace of inflation. In October, the ECB held its policy rate unchanged after having raised policy rates at the previous ten meetings in a row while the Federal Reserve has maintained its policy rate unchanged in the last two meetings. In Sweden, policy rates were raised to 4%, from a low of -0.25% in 2018.

Central banks have succeeded in bringing down inflation after continuous rate hikes, but inflation remains above 2%, the target set by most central banks to ensure gradual increases in the general price level. In the meantime, there is a broad call or expectation that central banks should or would begin cutting interest rates in 2024. This is misguided and presents a major challenge to central bank credibility.

High-interest rates have slowed consumer demand

When central banks began raising interest rates in response to higher inflation, the Riksbank raised its policy rate to a lesser extent in comparison to the Euro Area and the United States (U.S.). This caused consumption to slow in all three economies, but Swedish demand slowed much further as households were more sensitive to higher interest rates. Between 2022 and Q3 2023, domestic consumption in the U.S., Euro Area, and Sweden fell from highs of 6% 11%, 9%…