Surging inflation and hawkish central banks have sent markets lower and ignited recession fears. Are central banks pushing economies into recession?
The current year has been one of the weakest in decades in markets. Broad equity indices have plummeted on both sides of the Atlantic. The S&P 500 is well over 20% below the year’s start, and the European STOXX 600 is almost 20% down. And the tech-heavy Nasdaq index has lost over 30% since November’s top.
Inflation is running above 8% in the US and in the Eurozone, and inflationary pressures do not show any signs of weakening. This has moved central banks’ communications and actions towards faster tightening of monetary policies across the developed world. Government bond yields have moved rapidly higher and bond indices have fallen markedly from the year’s start. High inflation adds to investors’ worries, as cash is currently a sure way to lose money.
Investors’ expectations for this year were muted well before the turn of the year. Central banks in the developed world were preparing the shift away from zero interest rate policies as inflation turned out to be much stickier than previously thought. Inflation was pushed higher due to pandemic related supply chain disturbances and disruptions in energy markets. In the US, in particular, inflation was also due to ultra-expansionary fiscal policy.
The inflation problem was aggravated by the war in Ukraine, which pushed global energy prices to record highs. Another surprise this year has been the continued Covid-19 outbreaks in China. The authorities reacted to outbreaks with massive lockdowns in large cities, which had global repercussions through production stoppages in factories and severe logistics problems.
All this was already well-known. What is behind the renewed weakness in the markets during recent weeks? The main reason behind the re-pricing in the markets is that central bank communications and actions have turned more hawkish, as the expected peak in inflation didn’t materialise in the spring. The Fed hiked the steering rate last week by 0.75 percentage points, a move not seen since 1994. The ECB indicated a week before that the first and the second rate hikes will take place in July and September.
Market expectations of central bank rate hike cycle moved up substantially both in the US and in Europe. Also the Fed decision makers see the steering rate rising from the current 1.50-1.75% range to close to 3.50% by the end of the year.
At the same time as this hawkish shift in monetary policy, business and consumer confidence indicators have weakened, and forecasters have revised down economic growth projections. Softening real economy indicators and more aggressive rate hike projections stoked global recession fears.
But is recession unavoidable? In the US there is a gap between how people feel and how the economy performs currently. Consumer confidence has plummeted along with surging inflation. The labor market has, however, remained strong with brisk job creation.
Economic growth will slow down, as financial conditions tighten. But will the US fall into an outright recession? I am still hesitant on that. The Fed faces a classical central bank problem, where getting inflation under control requires higher interest rates, but at the same time higher rates dampen growth and job creation. As inflation is clearly the top priority for the Fed currently, the risk of the US economy slipping into a recession cannot be excluded. But currently I don’t consider it as the main scenario.
One can also argue that with the Fed the stakes are much higher than just the inflation and growth outlook of the US. Bringing inflation down is a must in order to sustain the credibility of the Fed in the eyes of the general public, market participants and investors at the global level. The Fed losing credibility would threaten the stability of the whole global financial system.
Just looking at the market pricing, it seems that investors still trust the Fed in the fight against inflation. The average expected inflation over the five-year period that begins five years from now, that is, long-run inflation expectations calculated from the yield curve, have remained stable at around 2.5%.
In the Eurozone the problem with rate hikes is even more complex than in the US. The cyclical position is weaker to start with in Europe. In the US rate hikes are cooling down the economy which is running hot. Whereas in Europe growth and job creation are weaker. And in the Eurozone a larger part of inflation stems from higher energy and food prices, which monetary policy cannot affect. In addition, higher interest rates are pushing heavily indebted member countries into the danger zone once again.
Higher costs of borrowing for southern European countries have re-ignited investors’ concerns about financial fragmentation in the Eurozone. The interest rate spread of Italy and Spain over German government bonds has widened recently. The ECB held an emergency meeting last week due to sovereign bond market developments. The communications after the meeting were scarce, but the ECB pledged to speed up the plans to create anew anti-fragmentation instrument.
I believe that the Eurozone is much closer to slipping into a recession than the US economy. The war in Ukraine and its economic impact is creating uncertainty and pushing up prices. The problem of financial fragmentation is real, and it will most likely put brakes on the ECB’s rate hikes later this year. Stagflation, that is, weak growth and rampant inflation at the same time cannot be excluded if inflation spreads to wider price categories and to wages, and the ECB’s room to manoeuvre is constrained by political considerations related to financial fragmentation.
So, are central banks pushing economies towards recession? It is quite clear that their intention is not to do so. However, it is true that the impact of tighter monetary policy on inflation works through the real economy. Higher interest rates dampen firms’ investments and households’ consumption, which slows down economic growth and job creation. In addition, there are external factors which make the central banks’ job harder. The war in Ukraine and its global impact on energy and food markets as well as the lingering impact of the Covid-19 pandemic create uncertainty and keep inflation elevated.
What does all this mean for investors? Only one thing is certain, volatility in the markets will continue. The first half of the year has been tough for investors. The market correction has brought valuation multiples in the stock markets closer to the long-run average. Earnings expectations have still remained fairly steady. So, if recession worries materialise, more volatility is in the pipeline. Tightening financial conditions and a weakening real economy most likely imply a challenging latter part of the year as well.
It will be a fine balancing act for the central banks in the developed world to tighten policy and reign in inflation without driving the economy into a recession. Both wisdom and a bit of luck is needed. Let’s hope that they have both.