Perspectives

Interest rates: hikes into next year, then central banks will change course

Published: Sep 2022

Europe will likely enter a recession soon, or is already in recession, as a result of deeply negative real wage growth, a fall in confidence levels and a sharp deterioration in the trade balance due to higher bills for energy imports.

Following on from this, it is strange that further ECB rate hikes are being considered. If the European economy enters a recession, inflation will come under downward pressure as demand cools and unemployment will increase. This will curb further increases in wage growth while it will encourage more savings and put extra downward pressure on asset prices. In this case, further rate hikes will only deepen the recession. Of course, this has the advantage that inflation will decline faster, but a very high economic price will have to be paid for this. Certainly with the towering debts in the background.

However, there are more factors involved:

  • Various developments suggest that the recession may well be brief and mild. In Europe, for example, fiscal stimulus is being rolled out and interest rates are far lower than inflation, suggesting that monetary policies are still loose. In addition, there is a great deal of pent-up demand as many corona measures have been lifted, and many companies want to cut production abroad due to geopolitical tensions. Furthermore, it looks as though inflation will decline fairly quickly at the end of this year or early next year. First of all, because comparisons will be made with far higher price levels before too long, but also because commodity prices could plummet in a recession.
  • Labour markets are tight in many European countries. As a result, there is a risk that unemployment will increase with a lag and that in the meantime additional wage increases will be evident, just as inflation starts to decline. In other words, purchasing power will recover quickly in this case, increasing the risk of a wage-price spiral.

In view of the above, it is quite possible that the recession will be too short and too mild to sufficiently reverse the inflationary mindset. Hence, a further deceleration via higher interest rates will likely be desirable, even though the European economy will shortly lapse into a recession of its own accord.

Many uncertain factors

Needless to say, the next question concerns the extent to which interest rates will have to be raised to achieve the desired goal. There are widely differing opinions on this, as the answer depends on all manner of developments that are very volatile:

  • Late August, Saudi Arabia announced that it wants to cut oil production as oil prices have come under downward pressure – mainly due to fears of an impending recession. If Riyadh follows through with this, oil prices are unlikely to decline significantly. In this case, inflation will decline less quickly and the recession will deepen.
  • Food supplies are highly dependent on the weather and on the amount of Ukrainian food shipments allowed by Russia. Both situations do not look particularly positive.
  • How long will pent-up demand persist, considering that many corona measures have been lifted? And, speaking of corona, many medical experts expect a new corona wave by the autumn.
  • Wage development is another uncertain factor. The risk of a wage-price spiral exists, but if a recession starts/has already started and the labour market loosens, wage increases may well turn out to be far lower than currently assumed.

Partly due to the aforementioned uncertainties, the Fed and ECB have abandoned forward guidance. Simultaneously, these uncertainties have clouded the outlook for both short-term and long-term interest rates.

The longer-term outlook for interest rates

Nevertheless, we can make a few general remarks about the level of interest rates:

  • The pattern expected by the markets is basically very plausible: interest rates will initially be raised further, until the economy weakens to the point where inflation and wage increases come under distinct downward pressure. By then, the monetary reins can gradually be relaxed.
  • We fear that the recession will have to be fairly deep and, above all, fairly long to keep a lid on wage growth and inflation. Central banks are unlikely to allow a recession to be deep due to the risk of a credit crisis given the very high debt levels. We therefore believe that they will open the money tap and lower their rates too soon. They prefer higher inflation to the risk of a credit crunch. Hence, inflation is unlikely to be depressed below 2%. It is more likely to keep hovering at 3%-4%, after which it will gradually rise again.
  • Interest rates are currently very low compared to nominal economic growth. This is understandable because real growth is very low, if not negative, because of exceedingly high inflation. Combined with the aforementioned positive factors for growth and the preference of central banks to avoid a deep recession, this could mean that the recession could be mild – as mentioned before – and that the labour market will not loosen much. In this case, central banks will have to raise interest rates more than the markets price in in the coming years to prevent a gradual rise in inflation translating into a wage-price spiral.

If we combine these points, we expect the following:

  • Over the next two quarters, we expect the Fed and the ECB to continue raising rates at a rapid pace.
  • In the ensuing course of next year, we expect central banks to stop hiking rates and possibly cut rates in case the risk of a deep recession and credit crisis becomes too big.
  • In the even longer-term, this could lead to far higher interest rates than currently assumed, as by that time, interest rates will likely rise more due to excessively high and rising inflation.

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