Globally, central bankers like the Federal Reserve Board (FED) in the US have realized that they miscalculated the amount of inflation in the economy, and that it is not as transitory as first thought. To prevent another 70’s/early 80’s inflation spiral, central bankers have been talking very hawkish about higher interest rates over the next year or so.
Higher interest rates are not good for fixed income investments like bonds or equities. It is not surprising that both of these markets have struggled in 2022. Central bankers see interest rates having to be 2 % to 2.5 % higher than current rates over the next year to combat the current inflation problem. This would put short term rates at around the 2.5 % to 3 % range. I see this as a worst-case scenario which hopefully doesn’t come into play because current inflationary pressures begin to subside sooner and quicker than expected.
If interest rates do move to the 3 % range quickly, that would most likely indicate a US recession in 2023 or 2024. Interest rates moving up that fast tend to over tighten, slowing down the economy and bringing on a recession sooner than expected.
The reason a central banker would do this is they are more concerned about the negative effects high inflation rates have on a large portion of society compared to the negative effects of a recession.
High inflation affects everyone, especially lower income people, while a drop in stock and bond markets only affects investors, which is a much smaller portion of society. A recession does also affect workers, but current low unemployment rates and social programs will help assist those affected, reducing that negative impact.
Inflation has not been a serious issue for more than three decades, so lowering interest rates and providing stimulus to offset a recession in the past was easier to implement. Now central bankers have a real inflation problem to deal with, one they must win. Once all supply chain issues and the Russia/Ukraine conflict plays out, inflation may naturally decelerate, but will it be in the 2 % range everyone hopes for?
In summary, as interest rates start to rise, markets usually adjust and slowly climb higher. The amount and speed of the interest rate increases is what determines the outcome in 9 to 12 months. Right now, the markets appear to have bottomed and are slowly climbing higher. I expect that to continue as long as central bankers maintain a moderate stance on raising interest rates. If their position becomes more aggressive then we will have to look at a more moderate investment stance to reduce risk.
If you have any questions or comments, please feel free to contact me.
Best regards,
Bill Achtymichuk