Jerome Powell, Chairman of the US Federal Reserve, took people by surprise in comments where he stated that the markets need to assume that the fed will hike rates twice more this calendar year. The Bank of England, the central banks of Australia, Turkey and Norway have all hiked rates this month to curb inflation. In fact, central bankers globally all seem to subscribe to the notion that rates are not coming down anytime soon and may- indeed, head up first. What are they seeing that is bringing this groupthink into being?
The thinking amongst central banks remains biased towards further rate hikes given the persistence of inflation globally. We have argued many times that this inflation, initiated by supply side shocks (whether due to Covid lockdowns or the shock of war between two major producers of energy and agricultural commodities), where pressures have not only been overcome but have seen energy prices back to pre-war and pre-covid levels, should have seen deflationary pressures of late. The fact that inflation remains persistent can be put down to corporate profiteering from both energy and retail firms (especially those selling agriculture-based products- supermarkets for example) which is keeping prices rising at an uncomfortable pace. So, even with input prices falling prices are sticky on the higher side with food price inflation in the UK nearly double the overall inflation rate which is at 8.1%
In an earlier article we showed the multi-decadal highs for corporate profits in both the US and UK. In Europe nearly half of all inflation is driven by corporate profiteering.
Fig 1.
Source: IMF
Europe’s inflation rate is only partly due to higher energy prices filtering through into their production costs and the energy prices remain high because of having to replace cheap Russian gas with expensive LNG from Qatar, Norway, and the United States.
Fig 2. Inflation trends US/UK and Europe
But the declining trend in the graph above surely suggests that central banks ought to pause for the moment to see if the trend continues. Why kill growth if the trend is in your favour? Already Germany- the engine room of European growth, has slipped into recession. Why risk pulling down the more fragile economies with it?
We have discussed some of the factors that might have a bearing on rates remaining high. One of them was the necessity for the US Treasury to quickly build up a cash surplus after depleting it during the deficit waiver standoff the first half of this year. The ‘crowding out’ effect of high government borrowing will keep rates up whilst also driving some weaker firms (not to mention indebted poorer countries) to near bankruptcy.
The other reason why rates may remain high was also discussed in a previous article: the effect of the El Niño phenomenon which seems to have begun. This has been known to cause high commodity prices from wheat to copper (in Chile, for example, because of flooding in copper mines). If central bankers are getting reports of high agricultural inflationary pressure, then they may decide to keep rates on the higher side as a preventative measure.
High rates may endanger- even if unfairly, the current push for higher wages across the US, UK, and France (though there it is more of a protest against increased working years). These are viewed as more sacrifice-able than imposing caps on goods prices by both the major parties in both the US and the UK. The danger here is that there will be a fall in the standard of living overall for workforces whose wages have not kept up with inflation. This will subdue demand for longer than central banks want. Ultimately demand needs to pick up to sustain growth and wages need to catch up to that point where it can sustain growth. Although UK inflation stripped of energy costs is at a 15 year high it isn’t lagging wages that have caused it and suppressing wages will not address the problem without damaging longer term growth.
Central banks are armed with monetarist weapons and we have argued that they need policy weapons to control corporate greed. But they need to act with what they have and both the Norwegian central bank and the Bank of England reacted with 50 basis point hikes, the Swiss National Bank hiked by 25bp even though inflation there is near 2%. The European Central Bank has pencilled in another hike in 3 months-time already – even indicating that it may not be their last one.
Fig 2. The normalisation of rates
There is a school of thought that holds the view that high interest rates are now here to stay- not as the exception but as the rule. If we see the graph above for rates vs. inflation in the UK, we can see that the period from 2008 onwards represents an anomaly in a longer timeframe. The post financial crash low-rate world of 2008 was meant to accommodate a banking sector that had been thoroughly thrashed. The pandemic delayed the return to normalcy that was begun incrementally in 2017/18. It isn’t ‘normal’ for bank rates to be below inflation for any length of time (apart from periods of runaway inflation) because this acts as a disincentive for investment. The argument then states that with bank balance sheets much more robust and inflation high this is a perfect time (or opportunity) to return to a state where there were positive real rates of interest (interest rates higher than inflation rates).
What this means for bond traders is that earnings are going to be harder to come by if they are looking for the fall in yields. What it means for mortgage holders in the west is that they are going to pinch a lot more than anticipated for an extended period of time. What it means for borrowers in general will impact investment decisions. In a world of high inflation savers/ investors will look for positive returns or there will be a savings gap which will affect the ability to raise capital down the road.
There is still a lot of cognitive dissonance between what the market expects (based on recent history) and what the central banks seem to have in mind. A lot of uncertainties also abound about the strength of global recovery or the effect of the El Niño weather phenomenon on inflation. Expect rates to be sticky on the higher side without a downward move for the foreseeable future.