With consumer prices rising rapidly in 2022, central banks worldwide had little choice but to raise interest rates aggressively. As PGIM Fixed Income Chief European Economist Katharine Neiss sees it, that strategy is working effectively to tame inflation but also poses economic risks for the remainder of 2023 and beyond.
‘There’s no dispute that higher interest rates from central banks are going to help cool economies and bring inflation back to target,’ Neiss said in a recent interview with MA Financial Media. ‘The question is, have they done too much?’
CENTRAL BANKS WALK A POLICYMAKING TIGHTROPE
By raising rates so quickly over a short period of time, Neiss wonders if policymakers have risked overtightening and tipping economies into recessionary territory, particularly in Europe. Yet she acknowledges the tightrope that central banks walk when adjusting monetary policy. Beyond possibly triggering a recession, rapid rate hikes pose a danger to financial system stability—as we saw with banking industry turmoil this year—and to countries drowning in debt. External shocks such as the COVID-19 pandemic and Russia’s invasion of Ukraine also play a role in policy decisions.
‘Central banks really have to balance multiple objectives,’ Neiss says. ‘The best thing they can do is to help facilitate an economy to adapt to these shocks.’
Inflation has indeed moderated in recent months but remains elevated. While Neiss expects it to keep falling, she also thinks it could hover just above most central banks’ target of 2%. The reasons differ by region, however. In the U.S., she sees the culprit as a strong labour market, while persistently high energy costs could keep prices elevated in Europe.
OUTLOOK UNCERTAIN FOR MORE RATE HIKES
Whether central banks will keep raising rates is an open question. The US Federal Reserve has signaled one or two more increases may be necessary this year. In the UK, Neiss expects a rate cap of about 6% from the Bank of England unless the pound weakens significantly.
‘The UK is uniquely challenged because it’s experiencing a double whammy from a tight US labour market and high energy prices in Europe,’ she said.
Although current conditions may remind investors of past periods of uncertainty such as the Global Financial Crisis (GFC) in 2008-09, Neiss noted that the triggers were much different. In the GFC, unwinding an inflated housing market led to extreme stress in financial markets and banking systems worldwide. Today’s volatile environment began with a global pandemic that led to widespread lockdowns and economic slowdowns. The bond market fallout from the current crisis is that low-quality issuers may struggle to refinance, Neiss said.
ANTICIPATING A NEW BOND BULL MARKET
So after three years pandemic-related health scares, plummeting financial markets and a banking industry crisis, can investors anticipate a new bond bull market? Neiss isn’t sure. If the aggressive rate-hiking cycle leads to a global recession, then central banks may lower rates to stimulate economies. However, if inflation remains elevated, central banks won’t have the flexibility to slash interest rates to near zero the way they did during the GFC.
‘We really do need to remember that this time is different going forward,’ Neiss said.
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