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Central banks in western Europe may need to keep interest rates at high levels until 2025 — much longer than financial markets are expecting — to guard against stubborn inflationary pressures, the OECD has warned.
In its latest economic outlook, the Paris-based OECD said it expected the European Central Bank to hold its policy rate at current levels until the spring of 2025, while the Bank of England might not start reducing borrowing costs until the first months of that year.
That would mean keeping rates high for a longer time than the Federal Reserve, which the OECD said would start cutting in the second half of next year.
The prospect of sticky inflation came alongside a softening growth outlook amid tighter financial conditions, slower trade expansion and ebbing business and consumer confidence, the OECD said.
Clare Lombardelli, the OECD’s chief economist, told the Financial Times the organisation was expecting a “soft landing” in leading economies after central banks sharply raised rates, but she added: “Monetary policy is going to have to remain restrictive for a period of time — we are still worried about inflation persistence. You are going to need real rates to be high.”
Senior policymakers have been stressing it is far too soon to be talking about reducing rates after many of the major central banks put policy changes on hold this autumn. But markets are questioning that message as growth slows and headline inflation rates retreat, prompting investors to price in rate cuts as soon as the summer of 2024.
Expectations of earlier rate cuts in the US have grown this week after Christopher Waller, one of the Fed’s most hawkish policymakers, signalled that rates were unlikely to rise further and could be cut if inflation continued to slow.
But in its outlook, the OECD, which represents rich countries, warned the “full effects” of the cumulative tightening over the past two years had yet to be felt. Monetary policy would need to remain restrictive until there were clear signs that underlying price pressures were being “durably lowered” and as short-term inflation expectations fell.
The OECD noted that while there had been an easing in core inflation rates, which exclude food and energy, more than half of the items in inflation baskets in the US, the euro area and the UK still showed annual inflation rates above 4 per cent.
Lombardelli said the Fed’s longer monetary tightening cycle and persistent downward inflation in the US would allow it to start lowering rates sooner than the ECB. Potential growth in the US was also higher than in the euro area, she added.
Christine Lagarde, ECB president, said this week that eurozone inflation was likely to rise again in the coming months and it was “not the time to start declaring victory”.
Investors are pricing in the first quarter-point rate cuts by both the Fed and the ECB by June, followed by a further two or three cuts over the remainder of 2024. The Bank of England is expected to move later, lowering rates for the first time by August, with one or two further cuts to follow before the end of the year.
The OECD forecast that average inflation in the G20 economies will ease only gradually, falling to 5.8 per cent in 2024 and 3.8 per cent in 2025, compared with 6.2 per cent in 2023.
The OECD noted that there had been a particular slowdown in sectors sensitive to high interest rates, particularly housing markets, as well as in economies that depended on bank finance such as the eurozone.
Global growth will weaken to 2.7 per cent next year — the most sluggish rate since the financial crisis except for the first year of the pandemic, the forecasts show. When inflation abated, allowing real incomes to grow, the world economy should record growth of 3 per cent in 2025, the OECD said.
While rates would be “mildly restrictive” in many countries next year as energy subsidies were finally phased out, the OECD warned that many rich countries faced “sizeable risks” to their long-run fiscal sustainability without more significant efforts to rein in public borrowing.
Many of them were set to record primary budget deficits this year and next, indicating it would be harder to lower debt ratios, the OECD added.
Growth in China is tipped to slow to 4.7 per cent next year from 5.2 per cent in 2023, amid slow consumption growth and weakening activity in its struggling real estate sector. Continued “structural stresses” in China were one of the main downside risks to the global growth outlook, the OECD said.
“There is a clear risk that the property crisis could have a larger and longer-lasting impact on the Chinese economy than projected,” it added.
Additional reporting by Martin Arnold in Frankfurt
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