The interest rate tightrope

Uncertainty is creating volatility; the war in Ukraine, the crazy Trussonomics scenario in September to October 2022 in the UK, and China’s zero Covid policy are just the tip of the iceberg. The world today seems absolutely bonkers and makes it very difficult to see a clear path ahead, writes Colm McGrath, Managing Director of Surety Bonds.

I did write in my most recent article that inflation in Ireland, Europe, and the US were running at record levels, but recent figures (ECB forecast year-end annual inflation of 8.1 per cent down from 10.7 per cent and the US Federal Reserve Board [the Fed] advising mid-January of annualised inflation of 6.5 per cent compared to 8.2 per cent) suggest that it has peaked and is decelerating due to aggressive interest rate hikes by the Fed and the ECB. This seems to be the case based on recent reports by both parties and independent economists.

Whilst there is or was a need to increase interest rates to battle inflation, my concern is whether central banks globally are overtightening. In particular, the ECB and the Fed, in their attempts to get to the holy grail of their 2 per cent target in such an aggressive manner, are causing economic damage. The primary objectives of both are to maintain price stability, ultimately preserving the purchasing power of their currencies. Price stability does create conditions for more stable economic growth and a more stable financial system, but I would argue this would apply under more normalised conditions.

Why 2 per cent? Because this is the rate adopted by Don Brash, the then-governor of the Reserve Bank of New Zealand in 1988. Inflation targeting then became the rage with other countries adopting it throughout the 1990s. Is 2 per cent really the optimum for today’s environment? Would 3 per cent or 4 per cent really be that detrimental? In my opinion, it would not be as bad and certainly would be better than pushing a potential recession. Higher rates would also allow for greater growth and allow central bankers more space to cut rates when needed.

The holy grail of 2 per cent inflation, which is the so-called optimum for a balanced economy, is not really possible in the current uncertain and volatile world we live in. The current thinking by central banks of fast and furious interest rate hikes is to crush demand, reducing employment which in turn should reduce inflation, but the downside may cause a recession. If the truth were to be told, neither the Fed nor the ECB can control prices as this is a supply versus demand issue.

“The holy grail of 2 per cent inflation, which is the so-called optimum for a balanced economy, is not really possible in the current uncertain and volatile world we live in… If the truth were to be told, neither the Fed nor the ECB can control prices as this is a supply versus demand issue.”

The medium- to short-term goals should be more balanced, a levelling off, lower increases or a halt to increasing interest rates is paramount, we need to see if these hikes have already taken hold as further increases, particularly high raises, could unintentionally push the globe into a much more protracted recession than is required. If this were to happen then this would leave central banks with very little ammunition to rectify the situation, such as reducing interest rates and reverting to quantitative easing to counteract such a problem.

Blackrock Investments state: “Bringing inflation down to 2 per cent targets will mean significant economic damage, in our view. Why? There is constrained production capacity in developed economies. The labour market and consumer spending patterns in developed economies have not fully normalised. The result: a mismatch in supply and demand, particularly in the services sector.”

In Ireland, this impacts even more so on the construction sector. Demand remains dramatically high while supply is low and reducing. The Irish Times headline “Construction activity shrinks amid cost concerns” highlights that residential units being developed are down 10 per cent, driven by a drop in apartment starts. Even more worrying is an article in the Irish Independent on 22 January 2023, intimating that private rental schemes backed by large institutional investors are dead in the water. This, if true, is a frightening scenario and means Ireland will miss its low-level target of 29,000 homes in 2023, at a time when we should be increasing output. Two main factors driving this reduction are cost uncertainty as material and labour costs remain volatile and the unpredictable nature of funding which has been driven by the movement of institutional investors to change their investment strategies.

A protracted recession with depleted central bank arsenals leaves highly indebted countries open to the debt markets. That is when government bonds start to become too expensive leaving them to struggle to refinance their ongoing debt needs. On top of this we could also see a period of stagflation: “The danger of stagflation is considerable today,” the World Bank warned. “Several years of above-average inflation and below-average growth are now likely.”

Economic slowdown, increased unemployment with consistent high inflation, this is all down to timing effects of monetary policy while so many other elements are outside of central banks control, such as the bottlenecks of increased price of gas, ongoing supply shortages in construction, chip manufacturing, labour, etc driving up costs. Could we be looking at another 1970s type of shock, whereby high interest rates caused a major recession followed by country debt crises? I hope not, and the thinking is central banks have actioned solutions much quicker this time around. The tight rope they are walking now is wobbly. Let us hope they can maintain their balance.

T: 086 8189 702
E: colm@suretybonds.ie
W: www.suretybonds.ie