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This is the clear message sent by all major central banks recently. Growth is about to be sacrificed on the altar of inflation.
There has been an unprecedented series of moves since the start of the month. On 6 September, the Reserve Bank of Australia raised rates by 0.5%. It was followed the next day by the Bank of Canada with an increase of 1.25%. On 9 September, it was the turn of the European Central Bank (ECB) to announce a hike of 0.75%, with the US Federal Reserve (Fed) following suit on 21 September. This series was brought to a close by a 0.5% increase in key rates by the Bank of England on 22 September. All highlighted the same objective: to firmly combat the current wave of inflation without regard for the negative impact on economic growth. Furthermore, they were unanimous in announcing that this is but one stage in the journey of monetary tightening.
With this stance, central banks are seeking to cool demand, whether derived from consumer spending or from public or private investment. But this cure is not without knock-on effects. Firstly, it automatically increases the cost of public borrowing for governments, some of which are already in a delicate financial situation. Secondly, this tightening directly depresses the real estate market due to its impact on credit. In addition, companies will need to reassess their investment plans to take account of higher costs of capital. Lastly, this decision has resulted in investors’ widespread aversion for the risk buffeting financial markets. Why buy equities today if corporate earnings may be crippled by GDP growth? Why lend to governments today while public debt continues to grow and the rates offered tomorrow may be more attractive? Why buy corporate bonds today if the contraction in growth may undermine creditworthiness? Investors seem to be taking an extremely cautious approach to all of these questions at the moment. Although the remedy applied by central banks is painful, it looks to be a necessary evil if we are to avoid triggering self-fulfilling effects on inflation.
However, a soft landing – i.e. a slowdown in growth without a period of contraction – does not seem to be completely excluded, as Jerome Powell indicated in his latest press conference. But this process now looks more akin to trying to land a plane on a stormy night than touching down in good weather and broad daylight.
Volatility on financial markets is likely to last for a few more months, until investors can see when central bank policies are likely to shift and, most importantly, have some idea of the extent of the economic slowdown.
26 September 2022, Olivier de Berranger, CIO, LFDE