The global race to hike rates tilts economies toward recession
The Fed looks willing to tip the US into a slump if that’s what’s needed to beat inflation. Other central banks are ready to make the same gamble
Central banks are intent on driving the world economy perilously close to a recession.
Late to see the worst inflation in four decades coming, and then slow to crack down on it, the Federal Reserve and its peers around the globe now make no secret about their determination to win the fight against soaring prices — even at the cost of seeing their economies expand more slowly or even shrink.
About 90 central banks have raised interest rates this year, and half of them have hiked by at least 75 basis points in one shot. Many did so more than once, in what Bank of America Corp. chief economist Ethan Harris labels "a competition to see who can hike faster."
The result is the broadest tightening of monetary policy for 15 years — a decisive departure from the cheap-money era ushered in by the 2008 financial crisis, which many economists and investors had come to view as the new normal. The current quarter will see the biggest rate hikes by major central banks since 1980, according to JPMorgan Chase & Co., and it won't stop there.
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'Bring Some Pain'
This week alone, the Fed is set to lift its key rate by 75 basis points for a third time, with some calling for a full percentage point salvo after US inflation again topped 8% in August. The Bank of England is predicted to boost its benchmark by 50 basis points, and hikes are also expected in Indonesia, Norway, the Philippines, Sweden, and Switzerland, among others.
As they slam on the brakes, policymakers are starting to lace their language with gloom in a public acknowledgement that the higher they raise rates to quell inflation, the bigger the risk they harm growth and employment.
Fed Chair Jerome Powell said last month that his campaign to rein in prices "will bring some pain to households and businesses."
European Central Bank Executive Board member Isabel Schnabel speaks of the "sacrifice ratio," jargon for the loss of output that will be needed to control inflation. The BOE goes as far as to predict a UK recession will be under way by the end of this year and may stretch into 2024.
There's little doubt that the monetary medicine will hurt. The question is, how much? Analysts at BlackRock Inc. reckon that bringing inflation back to the Fed's 2% goal would mean a deep recession and 3 million more unemployed, and hitting the ECB's target would require an even bigger contraction.
Adding to the uncertainty is the lag before rate hikes affect the economy, in addition to the makeup of today's inflation, much of which stems from energy and other supply shocks that central bankers can't control.
Investors won't escape the fallout.
Last week's higher-than-expected US inflation number for August sent the stock market into its steepest dive in more than two years, driven by bets on tighter Fed policy. Billionaire hedge fund manager Ray Dalio sees the prospect of a slump of more than 20% on equity markets as rates continue to rise.
'Credibility Is Everything'
Central bankers would rather keep their economies chugging along. They may at some point dial back their aggressive policy to try to ensure that. But their overriding focus now is to avoid repeating the mistake of the 1970s, when their predecessors prematurely loosened credit in response to slowing economies without first getting inflation under control.
That concern argues for pressing ahead forcefully with rate hikes, because allowing inflation to fester would risk greater economic pain in the longer term.
Anna Wong, chief US economist at Bloomberg Economics, estimates that the Fed will eventually have to take its benchmark rate to 5%, double today's level — a dose of further tightening that could cost the economy 3.5 million jobs and deal further blows to already-battered markets.
Likely also pushing central bankers on is the idea that they're already under attack for misjudging the pandemic-era price pressures, even if Russia's subsequent invasion of Ukraine worked against them, too.
Powell spent much of 2021 describing the inflation shock as "transitory," and he and colleagues entered this year predicting interest rates would need to rise by only 75 basis points in 2022. The Fed has already hiked three times that much.
Last November, ECB President Christine Lagarde said higher rates were unlikely in the euro area in 2022 only to find herself jacking them up 75 basis points this month and considering a repeat in October.
That action leaves policymakers with a lot at stake in winning the inflation battle.
"Credibility is everything for central banks, and it was dented by getting transitory inflation wrong," says Rob Subbaraman, chief economist at Nomura Holdings Inc. "Regaining credibility is their top priority even if it means tightening into recession — that's the lesson from the 1970s."
'It Takes Time'
In a sign that investors expect a US recession, yields on short-term US Treasury securities have risen above their longer-term equivalents by the most this century, with some bond traders betting that the Fed will have to ease policy in the later stages of 2023. Meanwhile, the S&P 500 is heading for its biggest annual loss since 2008.
A BofA survey of fund managers this month found that global growth expectations were near all-time lows.
One reason for this worry is that monetary policy works with a lag. It weakens financial markets first, then the economy, and finally inflation. So repeated jumbo rate increases become hazardous.
"It takes time to cool off inflation," says BofA's Harris. "If you start talking about only focusing on current inflation as your main indicator, you're going to be late in stopping" the tightening cycle. Harris sees the UK and euro area falling into recession in the fourth quarter as surging energy costs take their toll on economies this winter, and he expects a US downturn next year.
The US economy — and especially the jobs market — has so far proven surprisingly resilient. But economists say this simply means the Fed will have to push that much harder to cool off demand.
"Inflation and the labor market have proven more resistant to higher rates than the Fed anticipated," says former Fed Vice Chair Donald Kohn. "So they need to get rates up more now."
Until recently, it seemed like a no-brainer for the central banks to tighten policy. Inflation was sky-high, labor markets were strong, and interest rates were at rock-bottom levels.
But the trade-offs are getting tougher as high rates start to take a bite out of economies already suffering from the aftershocks of a lingering pandemic and Russia's war in Ukraine.
Borrowing costs in many economies, including the US, are turning from stimulative to restrictive. A surging dollar is hurting indebted emerging markets. A steep cutback in Russian natural gas supplies is raising the risk of stagflation in Europe, as prices soar while recessions loom.
Not Now, Later
Policymakers do still express hope they can pull off the trick of slowing inflation without completely derailing growth, and that eventually they will curb the tightening — but not yet.
"You do need to think of the middle ground at some point," Cleveland Fed President Loretta Mester told an MNI webcast this month. "But that's not a consideration at this point. That's a consideration for the future."
The single-minded focus on getting inflation down increases the chances that the Fed and other central banks will overdo it and crash their economies.
Dartmouth College professor David Blanchflower, a former BOE policymaker, accuses US central bankers of "groupthink" and charges that they're on a path to hammer a weakening economy to combat inflation that's already dissipating.
Complicating the central bankers' calculations: Inflation is being driven in part by climbing energy costs over which they have little or no control. This is especially the case in Europe, though it hasn't deterred the ECB or BOE from raising rates.
Central banks all over the world are pushing in the same direction, and that heightens the danger, says Maurice Obstfeld, a former chief economist at the International Monetary Fund.
"They risk reinforcing each other's policy impacts," says Obstfeld, who's now a senior fellow at the Peterson Institute for International Economics. They're also effectively engaging in competitive appreciation of their currencies and, in the process, exporting inflation abroad, he says.
Since 1980 the world economy has posted an average growth rate of 3.4%. Right now, with monetary tightening adding to the drags from Covid-19 and Russia's war, Obstfeld sees a risk that it could slow to "somewhere around 1%."
Put differently, former Fed Governor Kevin Warsh, now a visiting fellow at the Hoover Institution, says, "We have all the makings of a global recession."
— With assistance by Philip Aldrick, Zoe Schneeweiss, Maria Eloisa Capurro, Craig Stirling, and Michael Mackenzie
Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.
