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Raising Rates = Inflation Curb?

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Mar 01, 2023

US, UK, and European policymakers raise interest rates to keep up their fight against inflation and recession and must continue to act decisively to sustain global growth.

Raising Rates = Inflation Curb?

 The Federal Reserve, Bank of England (BoE,) and the European Central Bank (ECB) all raised interest rates last week, a quarter point, a half point, and a half point, respectively. They also signaled there could be additional hikes in the future. The ECB pledged to "stay the course in raising interest rates significantly at a steady pace." The BoE promised to keep increasing "forcefully" if needed. The Fed chairman said "a couple more hikes would likely suffice" for the Fed to feel comfortable with the position of rates.

The US, UK, and European economies experienced high inflation rates last year ranging from 6.5% in the US, to 9% in the UK and 10% across the EU. While rate hikes help temper inflation each central bank has attempted to balance use of the tool while seeking to avoid pushing their economies into recessions.

The view from the International Monetary Fund is that the global economic forecast is improving somewhat as China relaxes its zero-COVID policies and the world demonstrates remarkable resilience in the face of high inflation, soaring interest rates, and Russia's prolonged conflict against Ukraine. The IMF expects the world economy to grow 2.9% - down from the 3.4% growth in 2022 - due to the major central banks' aggressive interest rate hikes which have dampened consumer demand. Globally, the IMF expects consumer inflation to fall from 8.8% last year to 6.6% in 2023 and 4.3% in 2024.

The challenge for European economic policymakers is to manage interest rate adjustments so that inflation expectations can be anchored, thus eventually not requiring further rate adjustments. The risk with anchoring inflation expectations is the existence of inflationary dynamics - engrained in wage negotiations and price setting - which could spiral up, causing the ECB to lose its grasp on price stability. In other words, if an increase in prices is sustained by other market dynamics such as an increase in wages, rising interest rates will not have the same power to slow down or reduce inflation.

Meanwhile, the UK economy, is facing serious challenges and seems to be checking all the boxes for a recession: a steep decline in business activity, higher interest rates, low consumer confidence in dominant service sectors, staff shortages, strikes, an increase in government borrowing, and the soaring cost of servicing government debt are all fueling economic decline. Despite the gloomy start to the year, UK business for the coming year reached its best level in eight months, driven by hopes of an improving global economic backdrop and lower inflation.

The US economy ended 2022 on a solid note, and recent trends including favorable job reports, look to have Q1 continuing that performance. However, with unemployment at a 54-year low, wage pressure will play a role in the Feds' ability to manage inflation. After spending 2022 hiking interest rates, 2023 hikes may be more deliberate. Rates are now at the highest level since 2007, with additional increases on the horizon in the coming months. Consumers will continue to see higher rates for mortgages and credit cards, which should favor spending reductions. US GDP rose 2.9% in the fourth quarter, exceeding a forecast of 2.6%, but total spending slowed in December.

US mortgage applications and new housing builds were down 47% in 2022 from the fourth quarter of 2021, reflecting the sixth quarterly decrease in a row, per ATTOM, a real-estate data firm. With interest rates hovering near 7% and the Fed signaling rates could move higher, the housing market could continue its stagnation in 2023 despite monthly blips to the contrary. During a recent public question-and-answer session, Jerome Powell, Federal Reserve Chair, noted the positive recent trends on inflation, "but, it has a long way to go, and these are the very early stages." Powell went on to say he was confident that it would take until 2024 to reduce inflation to the 2% target level.

The IMF is counting on these central banks to keep up their fight against inflation and recession. These three economies, representing nearly 50% of the world's GDP, are interdependent and inevitably destined to share illnesses and infirmities. However, as policymakers, the Fed, BoE, and ECB must act decisively to sustain global growth and avoid the potential harm of eroding relationships; otherwise, they will face growing risks from global economic fragmentation.

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