Gulf is resilient as Fed holds interest rates

Once the cuts come, GCC central banks will follow

February 2, 2024, 7:44 AM

The supply-chain disruptions that caused global shipping costs to jump over the past few months may give the Fed pause for thought

On Wednesday the US Federal Reserve, the central bank of the world’s largest economy, chose to leave interest rates at a 23-year high of 5.25 to 5.5 percent, stating that rate cuts are coming in due course.

Interest rates have peaked following a cumulative increase of over 500 basis points (bps) since the end of 2021 but the Fed is unlikely to cut until victory is assured.

Inflation has proved to be stickier than many expected in the last two years. Nevertheless, it is dropping quickly, opening the window for the Federal Open Market Committee (FOMC) to seriously debate the right time for the first rate cut.

Once the cuts do come, central banks in the GCC will follow and move interest rates lower. Looser monetary policy will be welcomed and help stimulate regional credit growth. This shift should help maintain momentum in the real estate sector and support domestic investment.

On three- and six-month annualised terms, core US inflation is now running below the Fed’s 2 percent target.

And the markets have certainly been signalling that they believe the inflation fight has been won. They have been pricing in a cut in March, with rates then falling sharply through the rest of 2024.

The FOMC did not fully embrace the financial markets’ view because the central bank is not confident that inflation is moving “sustainably” toward its two percent inflation target.

While there have now been six months of better inflation data, it is still running ahead of the US central bank’s target on a year-ago basis. The Fed is therefore likely to err on the side of not cutting too quickly, especially given the robustness of the US economy.

In particular, the Fed wants disinflation to intensify in core services excluding housing, which is driven by the strength of the labour market, including nominal wage growth.

In the near term, the moderation in nominal wage growth will come via weaker headline inflation and continued re-balancing between labour demand and supply. The deceleration in nominal wage growth will, by extension, put downward pressure on core services inflation excluding housing.

The downside risks appear to be fading, arguing in favour of a gradual series of cuts later this year

The Fed should take some solace in the fact that a rebalancing of the labour market appears underway. The Employment Cost Index for private workers was up 3.5 percent year on year in the fourth quarter, which is what is needed to return inflation, over time, to the Fed’s target.

The resilience of the US economy was on full display with GDP expanding 3.3 percent in the fourth quarter of 2023. Monthly data also showed that much of the surprising fourth-quarter GDP strength took place in December, suggesting the economy is entering 2024 on a strong footing.

The downside risks to the economy appear to be fading, reducing the risk of a scenario where the Fed needs to cut rates more rapidly than we anticipate to support the economy. That argues in favour of a gradual series of cuts later this year.

The supply-chain disruptions which caused global shipping costs to jump at the end of last year and through January may give the Fed pause for thought. But we think that it is likely to look through this as the inflation impact is likely to be only temporary.

The Fed will get a couple of readings on inflation before its next meeting on 19 March, including annual revisions to the consumer price index, to reassure itself.

We expect it then to make the first rate cut to interest rates in May with three 25bps cuts this year. Markets now align on timing but still expect up to six rate cuts this year.

We do not get too hung up on whether the Fed cuts rates at its March or May meeting because the macroeconomic implications are minimal. The main issue is that markets like clarity.

With all this said, GCC economies do not need interest rates to fall rapidly. Regional growth has remained robust during the tightening cycle.

Despite inflationary pressures mounting in countries like the UAE and Saudi Arabia, particularly across the real estate sector, local economies are maintaining momentum.

Scott Livermore is chief economist at Oxford Economics Middle East