Are central banks pushing economies into a recession?

Rampant inflation has forced central banks to tighten monetary policy much faster than previously anticipated. Growth momentum in the global economy is losing steam after rapid rebound from the depths of the pandemic. The war in Ukraine continues and the looming energy crisis threatens to push the European economies over the cliff. Will hawkish central banks drive economies into a recession, and what’s ahead for the markets?  

Recent months have witnessed large swings in the expectations of the future course of monetary policy. Changes in market expectations sparked high volatility in stock and bond prices. First recession fears intensified on both sides of the Atlantic in mid-June, which moderated rate hike expectations and sent stock prices up after a long slide. And then in mid-August persistent inflation toughened central banks’ stance on fighting inflation and turned markets down again.

The hot summer in the markets brought S&P 500 up by 17% and the European STOXX 600 by 10% by mid-August. Government bond yields fell by around a full one percentage point to 2.6% in the US and to 0.7% in Germany. Was it too good to be true? Well, a market rally, which is based on intensified recession fears is seldom sustainable.

As the inflation data released during the summer didn’t bring any relief to the inflation problem, both the Fed and the ECB emphasized their commitment to bring stubbornly high inflation back to the 2% target despite weakening growth outlook.

The ECB finally started to raise the steering rates in July by first 50 basis points and again in September by 75 basis points bringing the deposit rate from below zero to 0.75%. In the US the next 75-100 basis points hike by the Fed will come this Wednesday. The market expectations of the future steering rate paths have moved up considerably despite darkening growth outlook.

And what was the impact on the markets? The rollercoaster ride just continued. Stocks retreated both in the US and in Europe cancelling over half of the gains of the summer and government bond yields rose back to the highs of the early summer.

Recent months are a good example of how sensitive the markets currently are to changes in expectations of monetary policy. The near-term interest rate outlook overrides all other factors in this market environment.      

Current market expectations see the Fed steering rate rising from the current 2.25-2.50% range to well over 4% by the end of the year. Also ECB is expected to raise rates by around 125 basis points in total in October and December, which would take the ECB’s deposit rate to 2.0%.

Are markets ahead of themselves in expecting such large rate hikes? Amid persistent inflation problem these expectations seem reasonable. August didn’t bring any relief to the central banks, as inflation stayed elevated at 8.3% in the US and at 9.1% in the Eurozone. And more worryingly, core inflation, which excludes volatile energy and food prices ticked up to 6.3% in the US and to 4.3% in the Eurozone. So higher central bank rates are needed to tame the inflation beast.

But, and this is a big but, can the economies cope with such big rate hikes without slipping into a deep recession?  

The GDP declined slightly in the US both in Q1 and Q2. Two consecutive quarters with negative GDP growth is an often-used definition of a ‘technical recession’. This time the markets and the pundits have ignored this statistical fact, and quite likely for a good reason. Household consumption has continued to grow and labour market is still strong with unemployment at 3.7% and with relatively strong job creation.

Chairman Powell was, however, very clear on Fed’s priorities in the Jackson Hole conference in August. “We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.” What is interesting here is that “Keeping At It” is the title of the memoirs of the legendary Fed Chairman Paul Volcker, who killed inflation and drove the US economy into a deep recession in early 1980s.

I do believe that the US economy will fall into a mild recession as the Fed tightens policy as planned. Unemployment will inevitably rise, as higher rates kick in. This time the Fed listens Main Street instead of Wall Street, and the near-term outlook for listed equities look bleak in the US.

What about Europe, where the economic situation is more fragile. The war in Ukraine and the looming energy crisis dims the outlook further even without central bank rate hikes. My view that the Eurozone is heading towards a deeper and longer recession.

The current hawkishness of the ECB will not last long. I’m expecting the ECB to put the rate hike cycle on hold already during this fall due to the weakening macro outlook. The ’fragmentation’ of the Eurozone may also become an issue during the fall despite the new ’Transmission Protection Instrument’ launched by the ECB. Italy’s elections will be held on 25 September. The most likely outcome of the elections is political turbulence. Eurozone recession combined with lingering inflation is a toxic cocktail for listed stocks.

So, what’s ahead for the markets? In the US the slowdown is induced by the Fed, whereas in Europe the main drivers are the war and the looming energy crisis. Inflation will moderate on both sides of the Atlantic during 2023. However, inflation returning to the central banks’ target of 2% will take a few years at best.

One needs always to be cautious when projecting the future. I would, however, expect weakness in the stock markets to continue in the near term. Central bank rates are going up and most likely all rate hikes are not priced in yet. And amid heightened market volatility, I do believe that the US stock market is likely to perform better than the European one due to stronger fundamentals.

September 20, 2022
Anssi Rantala
Partner, Chief Economist