Global Recession Risk is Elevated As Central Banks Are Raising Rates

In recent days, major central banks have signaled their willingness to tolerate a global recession next year, pledging to further increase borrowing costs in their battle against inflation.

The heads of the European Central Bank, the Federal Reserve and the Bank of England raised rates by half a percentage point and said more increases were likely next year, although they acknowledged that their economies were weakening.

The biggest constraint in four decades, in addition to the growing risk, is that further monetary policy tightening will so undermine demand and hiring that it forces the world economy to collapse next year, very soon after the contraction caused by the pandemic.

Ethan Harris of Bank of America Corp. said that “We are right on the brink of a global recession”

Most major central banks have raised rates this year

This is in line with a global adjustment trend.

Reaching an inflation rate that we haven’t seen for more than 40 years alters what economists call the “reaction function.” Normally, they would be expected to ease credit as economies collapse to limit the damage to households and corporations.

Central bankers are going in the opposite direction with price growth well above their 2% targets even in the face of economic contractions and insisting that rates stay higher for longer to stamp out inflation, though many investors are betting the stance will not persist as economies falter and unemployment rises.

Harris said that “There is a growing feeling among central banks that they would rather risk doing too much.” “They don’t want to be left behind and have to go back and walk again later.”

Bankers made a mistake last year, downplaying the dangers of mounting price pressures in economies still struggling after the pandemic. That allowed inflation to spiral out of control, prompting this year’s swift reversal with huge rate hikes.

Having learned from their mistake, officials are now vowing to keep up their fight against inflation even though price pressures may be starting to ease, especially for goods, as economies slow and supply chains tighten. unclog

Inflation is starting to come out of its peaks

…Although it will take time to reach the 2% target of central banks

Because of what happened in the 1970s, they are concerned about the increase in price expectations and the incorporation of high pressures in their economies.

The chairman of the Federal Reserve said a few days ago that “The longer the current episode of high inflation lasts, the greater the chances that expectations of higher inflation will take hold.”

The ECB also has “more time to go,” said Christine Lagarde, president of the European Central Bank.

The Bank of Japan is expected to maintain its ultra-loose policy next week.

HSBC’s Joe Little in a report said that “If 2022 was a year of rising inflation, rising rates and falling stock market multiples, 2023 will be a year of macro cycle.” “We have likely reached the peak of central bank hawkishness as headline inflation rates begin to cool.”

Glogal Recession

The UK is already in a recession, is openly acknowledged by BOE officials, and their ECB colleagues assume the euro region succumbed to one this quarter. Both economies have been hit by high energy costs fueled by the Russian invasion of Ukraine.

The United States is less exposed to the damage that the war could cause, but is still in danger of a recession as inflation and higher rates hit the economy. Although the Federal Reserve chairman has refused to say a recession is in the offing, two of his colleagues pointed to a contraction in gross domestic product next year in projections released this week, said Mark Salveson of Reogocorp.

Even if all 3 central banks are willing to raise rates further in 2023, the increases will likely not be as uniform as this week.

Bonds

Chairman Jerome Powell left the door open for the Fed to backtrack to just a quarter point hike in February; while European Central Bank President Christine Lagarde told markets they are underestimating the ECB’s resolve. She suggested at least two more half-point steps were ahead and announced plans to start drawing down a reserve of almost 5 trillion euros ($5.3 trillion) in bonds, said Jim from WSJ Print Edition.

BOE rate cuts are catching on. Despite the fact that the majority voted this week to increase by half a point to 3.5%. Two of the officials opposed an increase, hinting that the policy should be relaxed soon. They believe that 3% is “more than enough to bring inflation back to target, before falling below target in the medium term”

The labor market is a key focus for all three central banks, Unemployment in the major developed economies, at 4.4% in the third quarter, is the lowest since the early 1980s, according to the Organization for Economic Co-operation and Economic Development. That’s driving up wages, increasing the pressure on companies to raise prices.

They also need the financial markets on their side. If they ease further, that undoes some of the higher borrowing costs

For 2023 the objectives are clear. “Central banks will shun riskier assets until the labor market starts to turn,” Deutsche Bank AG’s global head of currency research George Saravelos wrote on Friday. “The two largest central banks in the world, the Fed and the ECB, have given a clear message: financial conditions must remain tight.”

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Former Fed Chairman William Dudley told Bloomberg Digital Subscription The inflation complexity faced by each central bank is different. In the US, “it’s all about the job market”

Much of the inflationary momentum in the euro region comes from disruptions in energy supplies, with pent-up demand in the aftermath of the pandemic and the depreciation of the euro adding to the momentum.

That policymakers underestimate how quickly inflation can fall as growth slows and supply chains wracked by Covid-19 unravel is a new global concern. The threat is that his tough stance could make an already dire situation worse, deepening recessions that central bankers hope will be short and shallow.

Future inflation expectations are rising even as government price caps are easing the pain for businesses and households.

The UK is suffering the worst: energy prices in Europe and tight US-style labor markets. Wholesale natural gas prices are up sevenfold since mid-2021 and employment is 200,000 below pre-pandemic levels. Workers took early retirement or quit due to health problems.

With job openings still plentiful, labor shortages are driving up wages. The regular private sector wage is now growing at 6.9%, the fastest this century barring the pandemic.

“It seems to me that the Bank of England has the biggest inflation problem,” said Dudley.

Still, he sees the ECB as having the tougher job given the region’s exposure to Russian energy supplies and the vagaries of winter weather.

“They are worried about inflation,” he said. “On the other hand, they are concerned about the energy price shock and what that might affect economic growth. So I wouldn’t want to be in their shoes.”