Since 2000, we’ve grown accustomed to central bank policy moving in what we’d call long-run directional cycles. Central banks have entered a sustained period of tightening, or easing, until rates are at the ‘right’ level. Policy is then held for some time, often years, before the next cycle starts. It’s very different from the previous decades, where policy rates jumped up and down with much greater frequency. As far as we can tell, the market is priced for the post-2000 situation to persist but, what we could find is that the outlook is closer to the 80s and 90s.

These long cycles since 2000 relative to previous decades are probably due to a number of factors. One is that inflation has become far more becalmed. In fact, rather than inflation, it has been disinflation or even deflation that has become a problem, spurring long periods when policy rates were stuck at rates close to zero.

The moderation of inflation compared to the likes of the 70s, 80s and 90s has probably made central banks believe that their anti-inflation credibility has improved. If this is the case, the cost to the economy (in terms of higher unemployment) is relatively low when policy is tightened. Better anti-inflation credibility and relative stability in the public’s inflation expectations have probably bought more clarity of thinking amongst central banks when it comes to the extent of rate hikes, or cuts, needed to bring inflation back to target.

As a result, central banks do not have to be as aggressive, and often volatile, as they were in the pre-2000 period. We also have to bear in mind that one notable central bank, the Bank of England did not even have responsibility for setting rates before 1997.

So why might we go back to an environment that’s more like the pre-2000 period? One obvious answer is that inflation has risen. Of course, central banks have been able to moderate the price surge in 2021 and 2022 with the customary long-run directional policy tightening and have been able to start, or even get through the opposite easing cycle in the past year, or two.

The banks have not found that they have had to stop and reverse policy quickly during either the tightening or the easing cycle. That’s something that was more common in the 80s and 90s. But the problem as we see it is that inflation has not generally been bought all the way back to target and there are numerous structural factors, such as deglobalisation and the demographics of ageing populations that are likely to keep inflation more elevated.

In addition, there is a good deal of hysteresis in inflation expectations. Broadly speaking, once inflation surges, as it did in 2021 and 22 people are more likely to see the next, even small, spurt in inflation as the harbinger of a much bigger rise and will act accordingly by bumping up their wage demands, for instance. While we very much doubt that the volatility of inflation and hence volatility of central bank rates will reach the sorts of extremes we saw in the 1970s, 80s and 90s, we do see more volatility than much of that we’ve seen in the post-2000 period.

What might this mean in a practical sense? If we take the US, for instance. Will the Fed bring the fed funds target rate steadily down to what the Bank considers to be a neutral level, say 3%, and then hold it there for possibly years before embarking on a new tightening cycle in the future, or another easing cycle? Steven Barrow, Head of Standard Bank G10 Strategy is not so sure. “Perhaps a more likely scenario is that the current economic slowdown pushes the Fed to lower rates to around neutral, or even lower, but persistent inflation forces the Bank to ‘tweak’ rates back up, possibly late in 2026 or 2027. Other central banks too could find themselves in a similar situation”, said Steven Barrow.