Central Bank Interest Rates

In my interview with the Financial Times published today I explain my current thinking about the European Central Bank’s monetary policy. I argue that R* is an important theoretical concept, but that it’s not well-suited to determine the appropriate monetary policy stance. The frequently quoted narrow range for R* is misleading because it only includes a subset of models. If you look at the R* estimates for Q3 including all models, the range goes up to 3%. Adding parameter and filtering uncertainty yields even wider confidence bands. But we do see that the overall range for R* seems to have moved up over recent years. I expect this trend to continue in light of high and rising public debt, huge investment needs for the digital and green transitions and increasing global fragmentation. A higher R* suggests a more cautious approach as regards rate cuts. Data show that the degree of monetary policy restriction has come down significantly, up to a point where I can no longer say with confidence that our monetary policy is still restrictive. Is the ECB behind the curve? No, we are right on track. Incoming data have confirmed that our gradual and cautious approach has been appropriate. But we are now getting closer to the point where we may have to pause or halt our rate cuts. The current time of high volatility is not the time to tie our hands through forward guidance. We are not pre-committing to any particular rate path. Given the decline in policy restriction, the direction of travel is not so clear anymore. Services inflation and wage growth are still at high levels and their deceleration still needs to materialise. Energy and food prices may offer surprises. I see risks to inflation as somewhat skewed to the upside. Disinflation may take longer than anticipated. I also gave some personal reflections on the upcoming update of our monetary policy strategy, regarding the target, the reaction function, the toolkit and scenario analysis. Thanks to Olaf Storbeck for conducting this interview in such an engaged way! The full text is found here: https://lnkd.in/ecdcyn4B

10yr TIPS at 1.8% (chart) is often compared to a guesstimate of #neutral rate to gauge restrictiveness. But the neutral rate, r*, may be higher in the new regime, and this old chestnut will probably be dusted out at #JacksonHole this week, titled "Reassessing the effectiveness and transmission of monetary policy". 3 drivers I monitor: 1/ expansionary fiscal spending and more transition related spending could push up REAL neutral rate. 2/ structural constraints such as labour shortage could push up long run INFLATION. 3/ offsetting upward pressures, trend GROWTH is likely a bit weaker than pre-pandemic.

Macro 101: What’s R*, the real equilibrium interest rate? When setting interest rates, Central Banks aim to achieve price stability (and in some cases also maximum employment like the Fed). To do that, they need to calibrate rates around their interpretation of neutral: raise rates above this level if you need to cool down the economy and price pressures, and cut rates below neutral if you need to stimulate the economy. This is why Central Banks use the concept of r* or real equilibrium interest rate. R* is the estimated real rate at which the economy doesn’t overheat or excessively cool down. The chart below shows r* in the US is estimated to be around +1%, which means that if core inflation sits at target the nominal neutral rate would be 3%. Given inflation has been running above target for years now, the Fed is applying a somehow restrictive policy with Fed Funds at 4.25% (above neutral). But what are the inputs Central Banks use when calculating r*? 1) Demographics: a bigger labor force means stronger potential growth and a higher equilibrium rate and vice versa 2) Productivity: a more productive use of capital and labor implies a higher equilibrium Rate and vice versa 3) The availability of risk free assets: an ample supply of risk free collateral implies higher equilibrium rate and vice versa Yesterday’s Fed minutes showed some FOMC members believe r* has increased given the persistent use of deficits (more supply of Treasury collateral) and AI-driven productivity gains. This would make the Fed 4.25% rate not so restrictive as neutral would be seen higher at around 3.50%. What do you think? 🖊️ Alf, Founder & CIO of macro hedge fund Palinuro Capital 👉 If you enjoyed this post, follow me (Alfonso Peccatiello Peccatiello) to make sure you don't miss my daily dose of macro analysis.

I actually wasn’t too surprised the RBA kept rates on hold. A lot of the commentary about why economists expected a cut but didn’t get one centres on the labour market. And while there have been job cuts, the market is still strong. Yes, some companies are reducing headcount. But it’s not a collapse. It’s a correction after the over-hiring we saw post-pandemic. These redundancies aren’t happening because demand has disappeared. They’re happening because costs have gone up and businesses are under pressure to protect profitability. Salaries have increased. Tech, compliance, and operating costs have surged. So companies are adjusting their structures to stay sustainable. According to the ABS (May 2025), unemployment is still low at 4.1%. Last month, 38,700 full-time jobs were added. The workforce participation rate remains high at 67.0%, and total hours worked hit nearly 2 billion for the month. That doesn’t point to a market in trouble. Seek's June 2025 data shows job ads are easing, but they’re still sitting above pre-COVID levels. Employers are still hiring...just being smarter and more selective about who and when. They are investing too...offices, tech, rebrands, sponsorship, events etc. We’re working with plenty of people who’ve been made redundant. But I’ve also seen a noticeable rise in people quitting ON THEIR OWN TERMS. That doesn’t happen in a downturn. They know they’ll land something new...and they usually do. Skills are still in demand. Talent is still moving. The labour market isn’t broken. It’s evolving. If anything, this is a reminder that workforce strategy matters more than ever. Productivity, high performance, the right hires, better retention, internal mobility...it all counts. This isn’t a downturn. It’s a reality check.

Third time is a charm I have been asked why the Fed shouldn’t cut rates to help low income households three times this week. The reasoning is that the labor market is weakening, which is a problem, especially for those who live paycheck to paycheck. There is also an assumption implicit in the question that marginal cuts in short-term rates will actually help those most in need. We are seeing the worst surge in many subprime loans since the aftermath of the Great Recession. I have a lot of empathy for the desire to shore up the labor market, especially on the heels of the government shutdown and the spillover effects it is having on contractors and the ecosystems that federal workers reside in. Threats by the administration to make layoffs and funding freezes to some states permanent in the high stakes’ showdown are even more worrisome, as it raises the risk that we may not recoup as much as usual when the federal government reopens. That does not mean rate cuts will help by much, given the inflation we are also enduring. There are three reasons for my reticence on rate cuts: 1. Subprime interest rates are much higher than those for higher credit score borrowers; any cut in rates represent little more than a drop in the bucket to lift the economic fortunes of those debtors. 2. Lower short-term interest rates tend to boost asset prices, which are already looking frothy. Those gains accrue more to affluent than low-income households, which worsens inequality and leaves more of the economy concentrated in the hands of a few households. The top 3.3% are doing particularly well already; the rest, not so much. 3. The inflation due to tariffs tends to hit low- and middle-income households harder than affluent households. Low- and middle-income households tend to rely more on imports, which means they are bearing more of the burden of tariffs, which are a regressive tax. The result is a cognitive dissonance on how to restore economic opportunities for low- and middle-income households. Indeed, there is a strong argument that the ultralow rate environment following the Great Recession fueled financial market gains and worsened instead of improved inequality. The moral of the story is that monetary policy is a blunt tool, especially when dealing with inequality. It can help spur growth but not evenly. It could even stoke an asset bubble, which could burst and deal another disproortionate blow to low-income households. Fiscal policy is better at addressing those issues. If a cut in rates goes too far and stokes a more persistent bout of inflation, then low-income households will suffer more, not less. Food for thought in a world where inflation and inflation expectations are both rising as the labor market weakens. Hence, Fed Chairman Powell’s fear that there is no “risk-free” policy choice at the moment. The Fed will cut next week but do so knowing that policy is still restrictive. Walking a tightrope.

EndGame Macro: A major shift is underway in global bond markets, and it’s starting in Japan. Japanese life insurers some of the largest institutional investors in the world are now selling Japanese government bonds (JGBs) at the fastest pace on record. Why? Because their duration gap has turned sharply negative for the first time in modern history. The duration gap measures the mismatch between the interest rate sensitivity of assets and liabilities. A positive gap means an insurer’s assets (like long-term bonds) respond more to rate changes than their liabilities (like annuity payments), which is generally manageable. But now, the gap has flipped to −1.48 years, the lowest on record. That means rising interest rates are hammering insurers: their liabilities are becoming more expensive faster than their assets can keep up forcing them to unwind long-duration holdings to stop further P&L damage. You can see this in the chart that from 2016 to 2020, insurers comfortably held a 4–5 year positive duration gap. But that edge eroded as Japan’s long-term yields rose and BOJ Yield Curve Control lost credibility. Now that the 30-year JGB yield has breached 2.75%, these insurers are facing mark-to-market losses and they’re being forced to sell into weakness. The second chart shows the result that net JGB flows from Japanese life insurers have plunged into deep negative territory through early 2025. This is not a tactical rotation it’s a systemic duration de-risking event, and it’s happening in the world’s most tightly held sovereign bond market. Why this matters globally: •Japanese lifers are major holders of U.S. Treasuries, European sovereigns, and global credit. If they’re de-risking at home, they may need to sell foreign assets too, creating ripple effects across global bond markets. •A withdrawal of Japanese capital means fewer buyers for long-duration debt at a time when the U.S. and Europe are issuing record amounts of it. •It signals the limits of central bank yield suppression. The BOJ may be forced to step back in with stealth QE or risk a bond market crisis. •It also injects volatility into FX markets particularly USD/JPY as capital flows repatriate or hedge mismatches widen. Bottom line: This isn’t just about Japan. It’s the leading edge of global duration stress. The BOJ’s failure to maintain policy control is forcing private capital to do what central banks fear most exit long duration at scale. The Japanese lifers are the canary. If this continues, other markets will follow. Watch the yield curve, watch FX hedging costs, and most of all watch what they sell next.

The story of Pakistani bank's stellar performance and why it is bad for economy. The Bank's in Pakistan are making exceptional profits for last few years, while rest of the economy is contracting - thanks to genius IMF advice enforced by independent State Bank of Pakistan (SBP) with respect to monetary policy to control inflation. With a policy rate at 22%, banks are engaged in risk-free lending to GoP at 23%, which results in highest spread in the world of 10 to 12%. Situation is so alarming that the entire domestic savings of the country (bank deposits), which are being used to finance the Govt's fiscal deficit, are insufficient to meet Govt's needs, and a significant portion of bank's lending to government has to be bridged by SBP's financing to bank's using open market operations (OMOs). This vicious cycle is actually causing more inflation for 2 reasons : 1) higher borrowing cost further increasing Govt's cost & fiscal deficit financed by SBP through banks at higher cost; 2) Credit requirements of private sector, who produce goods & services, have shrunk or become exorbitantly costly (as most businesses can not afford to borrowing at 25%), causing supply shortages and cost escalation that are inflationary. So effectively, this policy of increasing interest rates is creating more inflation instead of containing it, besides shrinking the economy. Furthermore, banks are making phenomenal profits without any risk-taking and innovation. Another implication of large financing for inefficient public sector projects is bulk of money from such projects goes into kickbacks & commissions which are expanding the cash economy as reflected in steep rise in cash in circulation. The size of SBP's OMOs through which it actually is lending to government routing the financing through banks, has increased to Rs. 9.4 triln by end of September 23, compared to less than 2 triln upto June 2021. Clearly, a major source of cash economy is the leakage in huge unproductive govt expenditure & fiscal deficits that are being financed by banks & SBP. Hence, major cause why there is low productivity and innovation in this economy is paltry domestic savings, which is largely wasted in financing unproductive government expenditure which generates significant portion of cash economy and does not contribute much to its tax collection creates more fiscal deficits -causing double jeopardy. Question is how to break this vicious cycle? The answer is simple, but not easy. The size of governments, at all levels, which have expanded disproportionately over the years, need to be drastically cut to reduce this unproductive expenditure, besides its excessive role in the economy to create space for private sector. https://lnkd.in/dBchtKDC

Same loan amount, same tenure, same credit score, but why are you paying higher interest than your friend? The RBI reduced the repo rate by 100 basis points in 2025, from 6.5% to 5.5%. Yet millions of home loan borrowers haven't seen their EMIs drop! Here's what's happening: In India, home loans follow different rate systems. → MCLR (Marginal Cost of Funds based Lending Rate) If your loan is on MCLR, your bank decides when to reduce your rate. They're not obligated to pass on the repo cut immediately or fully. → EBLR (External Benchmark Lending Rate) If your loan is on EBLR, your rate is directly linked to the repo. It resets automatically every 3 months. When the RBI cuts rates, you benefit within 90 days. The RBI mandated EBLR in 2019 for faster rate cuts - but only new loans got it automatically. Today, over 40% of existing home loans in India are still on MCLR or older systems like Base Rate! And, this isn't a small difference. Take a ₹50L loan over 20 years. → If you're on MCLR at 8.5%, your monthly EMI is ~₹43,391. → If you're on EBLR at 7.5% (post rate cut), your EMI drops to ₹40,280. That's ₹3,111 saved every month. Over 20 years, that's ₹7.46L in total savings! It would cost you anywhere between ₹25K - ₹30K to switch from MCLR to EBLR as a one-time fee. But the math works heavily in your favor. A small one-time cost could save you lakhs in interest. Send this to someone who needs this!

When RBI increases rates your EMI increases immediately but when RBI reduces rates your EMI does not fall! Relatable? In India, floating-rate loans work in 2 ways, MCLR: Bank sets the rate based on the cost of funds (till 2019) EBLR: Linked to RBI repo rate (from 2019 onwards) If you are on MCLR still, know that there is no standard procedure to pass the rate benefits to you. Banks do the change depending on their own process which is not transparent & frequency is also not defined & hence you see rate benefits not getting passed on to you when rates fall. On the other hand, if you are on EBLR, it is aligned every quarter to the benchmark & hence the transmission of rate is much better & faster. Surprisingly, more than 36% of total loans are still on MCLR & hence paying lakhs in Interest more. Please check with your bank, if you are on MCLR, move to EBLR. You can use the below format to write to your bank.

Why are global markets selling off? Global asset markets have seen meaningful correction in the last couple of days. We think the key trigger for this correction could be unwinding of the Yen Carry Trade and its trigger could have been the hawkish monetary policy announcement by Bank of Japan on 31st July, 2024. What is the Yen Carry Trade and Why is it unwinding: Carry trade is borrowing money in a country A and investing it to buy assets in another country B. One of the most popular carry trade in the last decade has been to borrow cheap money in Japan and use it to buy risky assets elsewhere in the world. Its seeds were sown in 2013, when Bank of Japan (BOJ) unveiled its shock - “Bazooka” monetary policy - for the markets. Japan has been maintaining a very low level of interest rates and ultra loose monetary policy ever since the big bazooka monetary policy of 2013. Low level of interest rates and huge quantitative easing meant that the Japanese Yen would maintain a depreciating trajectory versus other currencies. Trigger – BoJ change in policy stance: On 31st July, 2024, Bank of Japan decided to increase the interest rates to 0.25%. More importantly, it decided to reduce its monthly purchase of Japanese government bonds (JGBs), halving it to 3 trillion yen (~$20bn) in January-March 2026. More details in the attached short note. #investing