Interest rate upswing: game of catch-up at the risk of overreach?
The US Federal Reserve, which sets the tone for the rest of the world, delivered a more hawkish prognosis than expected for interest rates and monetary policy this week – a shift interpreted as an attempt to catch up with market expectations of seven rate hikes this year. Based on the US interest rate outlook, Fed Fund’s rate will end the year a full percentage point higher than indicated at the previous meeting in December last year after six more successive rate hikes. Another three rate increases are anticipated next year.
ING and others described the Fed’s anti-inflation stance as aggressive, with the bank seeing a 50-basis point (bp) increase in May as possible, following the 25bp hike this time. Sanlam Investments economist Arthur Kamp and Oxford Economics chief US economist Kathy Bostjancic saw the Fed’s tone as very hawkish, Bostjancic describing the bank as “very determined to lower inflation”.
Her expectations are for US rates to come in at 2.75% by the end of 2023, which would be above the downwardly revised long-run neutral rate of 2.4% (previously 2.5%).
“The sharply revised higher and more persistent inflation forecasts are the reason the [Fed] now sees the policy rate needing to rise more quickly and significantly higher to a restrictive level.”
Fed chair Jerome Powell downplayed the risk that rising rates could see recession, or even stagflation, saying the US economy is “strong and well-positioned to handle tighter monetary policy”. But bond market investors sold off US treasuries in response to his message, showing their scepticism that he will be able to raise rates so many times this year without damaging economic prospects.
The Fed also plans to draw down its almost $9-trillion balance sheet, in effect withdrawing the liquidity support so crucial in underpinning financial markets at the onset of the pandemic. It will do so by reducing its holdings of Treasury securities and other securities it holds, “at a coming meeting”, with expectations this will start in May.
Old Mutual Multi Managers investment strategist Izak Odendaal says central banks could face a tricky situation in which they will be forced to choose either to support growth or to fight inflation. However, he doesn’t envisage rate shocks or a rerun of 1970s stagflation because “the world has changed a lot since then”. However, he does hope the South African Reserve Bank won’t overreact to rising fuel and food prices.
“These price increases are actually deflationary in the sense that they reduce consumers’ real incomes – there is less money to spend on other things, which should place downward pressure on those other prices. Or, to put it differently, higher food and fuel prices act in the same way as interest rate hikes would in this environment. No need to hit the economy twice then.”
Europe is likely to be most at risk in the face of the tough choice central banks could face this year, with its economy the most vulnerable in the developed world. Odendaal thinks the ECB’s decision to focus on inflation may be a mistake and sees the Fed as in a better position, with the US experiencing strong growth at this stage, meaning it can afford to raise rates to address high inflation. Seven rate hikes and a couple of rate hikes next year would take the Fed Fund’s rate to 2–2.5%, which, he notes, is not high by historic standards. “The US should be able to handle it, given low consumer debt levels.”
The risk to this seemingly manageable scenario would be that markets start to worry if the Fed keeps hiking rates as the economy starts to slow down, resulting in an inverted yield curve, which is already flat, talk of recession, and a proper market meltdown.
Says Odendaal: “Hopefully the Fed takes it easy, continuously assessing things as they go along. The problem is that they want to give as much forward guidance as possible, but in this instance it is counterproductive. In this situation, you want to look at the data as it comes in and assess conditions.”
ING chief international economist James Knightley highlights uncertainty over Russia’s invasion as a key risk for the economic outlook, saying it will both put upward pressure on inflation and weigh on economic activity – a key reason for the less than 50-bp hike this week. However, he says: “Calls for more aggressive, swifter policy tightening would certainly build if inflation remains up around 8%, there is more evidence of a de-anchoring of inflation expectations, and the unemployment rate remains below 4%.”
On Russia-Ukraine talks, Knightley says a positive outcome would increase the potential for a 50-bp hike in May. However, there are no guarantees on the talks and there are uncertainties about how quickly supply chains will improve in light of China’s zero-Covid strategy and other factors.