When will the interest rate cut come? HSBC: At least these four conditions must be met.

After more than a year of aggressive interest rate hikes by the Federal Reserve, the European Central Bank, and the Bank of England, inflation is starting to cool down. The market believes that the interest rate hike cycles of the three major central banks are coming to an end, and pausing interest rate hikes has become the mainstream. The market is now betting that starting from April next year, the central banks of Europe, the United States, and the United Kingdom will successively enter a cycle of interest rate cuts. However, HSBC bluntly stated that it is still too early to bet on interest rate cuts.

On November 20th, a team led by HSBC senior economist Chris Hare stated in a report that they expect the Federal Reserve, the European Central Bank, and the Bank of England to not further raise interest rates. In terms of the timing of interest rate cuts, they predict that the Federal Reserve will cut interest rates in the third quarter of 2024, the European Central Bank will cut interest rates in the fourth quarter of 2024, and the Bank of England will not cut interest rates until the first quarter of 2025.

HSBC believes that the current market pricing for the pause in interest rate hikes by the Federal Reserve, the European Central Bank, and the Bank of England may be correct, but the pricing for interest rate cuts may be too dovish:

The market expects the Federal Reserve and the European Central Bank to cut interest rates twice before July next year, and the Bank of England to cut interest rates twice before September next year. We believe that these expectations are too dovish.

In the context of central banks around the world relying heavily on data, we believe that central banks want to see substantial signs pointing to deflation. However, by the middle of next year, they may still not have enough evidence.

So what kind of data does the central bank need to see in order to choose to cut interest rates? HSBC outlined four macro conditions, listed in order of priority:

(i) GDP growth below the long-term trend; (ii) Rising unemployment rate surpassing the "equilibrium" level (or signs of a significant cooling in the labor market, such as a decrease in job vacancies); (iii) Wage growth falling to 3.5% (HSBC believes this corresponds to a 2% inflation rate); (iv) Core inflation falling below 3%, with the key point being a clear downward trend towards 2%.

Therefore, the report points out that the current situation is that core inflation in the United States was 4% in October, core harmonized CPI in the eurozone fell to 4.2% YoY in October, and core inflation in the UK was 5.7%. There is still some distance to go before meeting the above conditions. HSBC believes that the United States is expected to meet these conditions in the middle of next year, while Europe will be later because wages and inflation in Europe are more sticky.

At the same time, HSBC also left itself a "way out". The report stated that even if their macro forecasts are completely correct and the imagined deflation and monetary tightening gradually occur, it is difficult to know exactly when policymakers will be ready to take action. Unexpected factors such as actual interest rate changes or wage agreements in the eurozone may disrupt the balance. HSBC also pointed out that there is a possibility of significant unexpected inflation data, which would contradict their judgment and future situations:

Considering the recent guidance from the Federal Reserve, the European Central Bank, and the Bank of England, if there is a significant unexpected inflation data or another energy crisis, this may trigger further interest rate hikes by central banks around the world. If wages and inflation are stickier than we anticipated, interest rate cuts may be postponed.

We also believe that there is a "dovish risk": given that we may not have seen all the effects of past aggressive rate hikes, central banks may have found the side effects of their excessive tightening policies and therefore need to start easing earlier.

Taking these risks into account, there will be some delicate policy decisions next year.

Condition 1: GDP growth rate below long-term trend

In theory, if the actual GDP growth rate is lower than the potential growth rate, the growth rate of total demand will be lower than the growth rate of supply, resulting in an output gap and possible deflation. However, there are two complex issues here.

First, what is the potential growth rate?

HSBC pointed out in the report that in the United States, the Federal Reserve maintains its long-term economic growth forecast at 1.8%, while the potential growth rates for the eurozone and the UK are slightly above 1%.

Second, supply growth may not be maintained at a fixed "trend" level (during the pandemic, both demand and supply experienced varying degrees of decline, and supply is flexible and may be influenced by external factors).

Looking ahead, assuming the economy does not face significant supply shocks, a GDP growth rate below the potential growth rate will result in idle capacity that can suppress inflation:

Therefore, although a GDP growth rate below the potential growth rate is certainly not a sufficient condition for interest rate cuts, it may be a crucial part of the start of deflation.

Condition 2: Rising unemployment (or clear signs of labor market slack)

HSBC pointed out in the report that persistent weak total demand is likely to eventually lead to reduced hiring, increased layoffs, and rising unemployment. The Phillips curve theory tells us that once the unemployment rate exceeds the non-accelerating inflation rate of unemployment (NAIRU), it indicates that the labor market may no longer be overheated, and wage growth is expected to eventually slow down and trend towards inflation levels below 2%.

Of course, HSBC stated that NAIRU is not directly observed and is usually estimated by observing the flow of matches between jobs and workers or the relationship between wages and unemployment rates. However, for interest rate prospects, it is important for central banks to determine their estimates of NAIRU:

In the United States, the Federal Reserve believes that NAIRU is 4%, while the Bank of England believes that NAIRU is 4.5% (in the November Monetary Policy Report, NAIRU was raised from 4.25% to 4.5%). The European Central Bank has not disclosed its estimate, but its view may not differ significantly from the estimate of the European Commission, which is 6.5%. However, the report emphasizes that although the rise in unemployment rate may be one of the backgrounds for interest rate cuts, it is not a necessary condition. If the unemployment rate remains stable or even gradually decreases, central banks may need to wait for other signs of labor market loosening to confirm the cooling of the labor market, such as a decrease in job vacancies:

Of course, it would be ideal if the labor market cools down in this form rather than the rise in the unemployment rate, and this is actually the market's judgment on the recent cooling of the labor market in the United States.

Condition 3: Wage growth rate drops to 3.5%

If the cooling of the labor market begins to lead to a decline in wage growth, the next key question is, what wage growth rate can match a 2% inflation rate?

HSBC believes that this "magic number" is approximately 3.5%. The reasons are as follows:

First of all, for company costs, what really matters is unit labor costs (ULC) - the cost of producing unit output. The growth of unit labor costs is mainly the difference between wage growth and productivity growth. Assuming that "trend" productivity grows by 1% per year, a wage growth of 3.5% means a unit labor cost growth of 2.5%, which is important because labor costs account for two-thirds of company costs.

Assuming that the growth of other costs will not exceed 2%, and the company's profit margin is relatively stable in the long term, then inflation will be highly consistent with the growth rate of ULC.

As an indicator that is theoretically lagging behind the development of past labor demand and past inflation results, we believe that wage growth does not need to be lower than 3.5% to trigger interest rate cuts, but it may not exceed 4%, and it is best to be in a downward trend.

Condition 4: YoY growth rate of core inflation is below 3% and gradually declines to 2%

HSBC believes that explaining the decline in overall inflation to 2% is not complicated, as the Federal Reserve, the European Central Bank, and the Bank of England all target this. In terms of observing data, the core inflation rate (excluding energy and food prices) is the key to whether overall inflation can decline, because generally, the impact of food and energy prices should "disappear" in the medium term.

HSBC believes that, like wages, the core inflation rate will also decline slowly. Therefore, the core inflation rate does not need to be as low as 2% to trigger interest rate cuts. If the core inflation rate is below 3% and in a downward trend, it may be enough for central banks to start an interest rate cut cycle.

Why is it 3%?

HSBC points out that although the number 3% is only their own judgment, both the Bank of England and the Federal Reserve have evidence showing that this number is crucial:

For the Bank of England, when the inflation rate exceeds the target of 2% by 1 percentage point (i.e., exceeding 3%), the Governor of the Bank needs to write an open letter to the Chancellor of the Exchequer to explain the reasons. So, exceeding 3% is an inflation rate that attracts the attention of the central bank.

For the Federal Reserve, the dot plot shows that the expected core inflation rate for 2024 is 2.5%-2.8%, which is the time when interest rate cuts begin.

Still a long way to go for interest rate cuts

HSBC pointed out that while the four conditions mentioned above may seem simple in theory, what is the actual situation? Judging from the current state of key variables, central banks around the world still have a long way to go, especially in Europe, particularly in the UK, where wage growth remains too fast.

Looking at the situation in Europe, with GDP growth almost reaching zero, the labor market remains tight (unemployment rates in the eurozone are at 6.5% and in the UK at 4.2%, reaching or below the official estimate of NAIRU).

Most importantly, wage growth is still too fast, with average wage growth in the eurozone in the second quarter at 5.6% and average weekly earnings in the UK in September growing by 7.9% YoY, which is still far from our defined critical threshold of 3.5%. Therefore, the core inflation rates in the eurozone and the UK in October were 4.2% and 5.7% respectively, still at uncomfortably high levels, which does not come as a surprise to us.

HSBC pointed out that in the United States, these key indicators do appear to be better, but still show significant cost and price pressures:

Core inflation in the US fell to 4% in October, which is more optimistic compared to inflation in the eurozone and the UK, but it is still a high inflation rate, and businesses also indicate that the overall condition of the labor market remains tight. In addition, the US economy has unexpectedly shown strong growth, with the third quarter of this year far exceeding the trend. This strong demand trend may further bring upward pressure on costs and prices.