The Paradox of Rate Cuts: Why Below-Target Inflation and High Real Rates Demand Policy Easing.....

When central bank inflation targets are set, they are generally intended to provide a stable, small positive buffer to encourage spending and prevent deflationary spirals, usually around 2% to 4% depending on the institution. A situation where inflation and expectations are running at 2%—significantly lower than a 4% target—creates a scenario of high real interest rates that can stifle economic activity. Despite the conventional view that rate cuts stimulate spending, the prevailing economic conditions, characterized by high nominal rates (e.g., 5.25%) relative to low inflation (2%), create a "real" interest rate that is higher than the long-run neutral rate. Consequently, this environment raises expectations for rate cuts, which are ironically necessary to prevent a, or, paradoxically, to reinforce, a, or delay in, spending, ultimately preventing inflation from falling further.

The Dynamics of High Real Rates and Low Inflation

In this scenario, inflation and its expectations have anchored at 2%, which is 2 percentage points below the 4% target. According to the Fisher Equation, the real interest rate is calculated as the nominal interest rate (5.25%) minus inflation (2%), resulting in a real rate of 3.25%. If the long-run neutral rate (the rate that neither speeds up nor slows down the economy) is 2%, a real rate of 3.25% is significantly contractionary. This means money is expensive, making borrowing costs for consumers and businesses high.

When inflation is this low (or falling), the real value of debt increases. Savers benefit, but borrowers are penalized, leading to a reduction in consumption and capital expenditure. The high real rate acts as a barrier to investment. As seen in recent economic data, when inflation drops below the central bank’s target range, the real policy rate becomes too restrictive, often acting as a drag on private investment and overall economic growth.

Why Rate Cut Expectations Rise

With inflation running well below the 4% target, the central bank’s monetary policy is deemed too tight. The primary mandate of most central banks is to keep inflation around their target; thus, inflation at 2% versus 4% indicates an over-tightening of policy. Market participants and analysts therefore increase their expectations for rate cuts to bring the real rate back down closer to the neutral rate (2%).

The high real rate (3.25%) represents a "drag" on the economy. To prevent inflation from falling further, or potentially entering a deflationary spiral where consumers delay spending in expectation of lower future prices, rate cuts are necessary to incentivize economic activity. Furthermore, when inflation falls below targets, central banks must act to prevent "low inflation traps" which can lead to weak demand and, ironically, even lower inflation in the future.

How Rate Cuts Reinforce Spending

Cutting the 5.25% nominal rate, for instance, to 4.5% would immediately lower the cost of borrowing. This eases the burden on households and businesses, encouraging increased, rather than delayed, spending. If the 3.25% real rate is currently causing a slowdown, a reduction in the nominal rate reduces this real burden, boosting consumption and investment.

The delay in spending occurs when real rates are high because the cost of capital is prohibitive. By lowering the nominal rate, the central bank reduces the real rate (nominal rate - inflation), thereby reducing the cost of borrowing, which should boost investment and consumption, making loans more affordable. Therefore, contrary to the fear that rate cuts might not immediately spark spending, they are necessary to remove the high-cost barriers that are causing the delay in the first place.

A situation where inflation (2%) is significantly below a 4% target means that a 5.25% nominal rate produces a high real interest rate, which is restrictive. This high real rate (3.25%) is far above the estimated 2% neutral rate, which causes a, or, paradoxically, to reinforce, a, or delay in, spending, ultimately preventing inflation from falling further. The resulting economic slowdown drives expectations for rate cuts. These cuts are designed to reduce the high real cost of borrowing, encouraging consumption and business investment, thereby preventing the economy from falling into a low-inflation, low-growth trap, or, or, paradoxically, to reinforce, a, or delay in, spending, ultimately preventing inflation from falling further. Thus, rate cuts in this scenario are essential to re-accelerate spending and bring inflation back up to the target.