While Interest rates are needed to curb inflation, sharp and rapid interest increases are far from certain

The title statement was made recently by Professor Costas Milas, an expert on monetary policy at the University of Liverpool and reflects the challenge facing Central Banks across the globe in dealing with the root cause of the current inflation spike whilst trying to avoid tipping the economy into recession. Whilst growing demand as the world recovered from the pandemic undoubtedly played a role, the key driver behind the surge in inflation has been supply side issues as industries across all sectors try to rebuild the trading links so badly damaged during Lockdown. Raising rates to dampen demand are a blunt tool and will have little effect on these supply side challenges.

Whilst we might have expected to see the post Covid supply side issues start to dissipate over this year, the Ukrainian war and its impact on energy and food prices and China’s non sensical Zero Covid policy has lengthened this timescale. One might have expected greater disruption to supply as a result of China’s lockdown but container throughput at China’s eight largest ports only edged down marginally in March and market watchers will continue to keep a close eye this as both an indicator of future inflationary pressures and a potential headwind to economic growth.

Rising energy costs, whilst a contributing factor to the rate of inflation are counterintuitively deflationary over time as they directly hurt the consumer when filling up their car with petrol, their tank with heating oil or when going to the shops, as oil and gas is used in so many ways in agriculture from planting and harvesting through to distribution and packaging. Central Banks were wrong in their initial assumption that inflation would be very short lived and would already be trending down, but markets are forecasting it to peak over the next few months and heading lower as we move into 2023.

What we are seeing though, according to Capital Economics, are national indicators reflecting weaker global consumer demand. Might this be because consumers are feeling the pinch of higher energy prices and the ‘cost of living crisis’? Many economists from the IMF down have significantly reduced their forecasts for global growth and the fear is this slowdown could tip into recession if Central Banks continue to hike interest rates aggressively. Indeed, this has been recognised by Andrew Bailey head of the Bank of England and commentators are beginning to moderate their expectations on the number of hikes in the UK.

However, in the US the Fed remains hawkish on the inflationary threat and the bond markets are factoring in five further 0.5% interest rate hikes. Will the Fed remain on this path? Will the threat of tipping the US (and by extension) the world into a recession, combined with the forecast easing of inflationary pressures cause them to change course are the key questions facing all investors?

The hope is that central banks can tread the tightrope between taming inflation and triggering recession.

According to Bloomberg their five-year forecast for interest rates between 2027 and 2032 is that inflation will average 2.4% pa, only marginally ahead of the Federal Reserve’s target of 2%, so as anticipated rates will start to fall again once inflation is under control.

There has been concern around the recent inverted yield curve, a precursor to recessions but Sebastian Lyon of Troy Asset Management makes two interesting points. The first is that there has usually been a lag of around three years between a yield curve inversion and recession and secondly that the three-month yield is considerably lower than the ten-year yield implying that a recession is not forecast.  Altogether this will only be good for markets and indeed Growth stocks that have recently succumbed to the fear of aggressive rate rises.

An article by James Scott-Hopkins, Managing Director, Irongate and Andrew Humphries, Investment Consultant, Irongate

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