"If your only tool is a hammer, every problem looks like a nail." This old saying still rings true as central banks keep ratcheting up the interest-rate pain. There's been minimal impact on wealthy households but a disproportionate effect on those who can least afford it. Better analysis of the furious pace of raising borrowing costs is needed urgently, along with more flexibility about reaching inflation targets and patience in letting monetary tightening do its job.
A global recession looks unavoidable if interest rates keep being hiked. We've had warnings from the gilt crisis, the collapse of Credit Suisse Group AG and several US bank failures. Plenty of other rate-sensitive sectors are wobbling, including over-leveraged commercial property and utilities. But the real damage is being done in other pockets of the economy such as small- and medium-sized enterprises and home renters.
So the stated aim of the Federal Reserve and its peers to “loosen” the labor market is misguided. Central bank mandates don't specify unemployment targets because the labor market is impossible to micromanage. When the tipping point is reached it's too late to prevent a swift downturn.
Business loans mostly have floating interest rates, so firms feel the pain in real time. The US manufacturing purchasing managers survey’s June reading of 46 signals contraction; Germany’s 40.6 number ought to be sounding alarm bells. Bank lending and money supply measures are slowing globally. Measures of input inflation, such as producer prices, are falling rapidly. Economies may not be slowing as quickly as central banks would like to curb inflation, but the direction of travel is clear — and at risk of accelerating.
The European Central Bank's annual global policy forum in Sintra, Portugal last week had one consistent message from its participating policymakers: More monetary tightening is coming, and borrowing costs will remain elevated for longer. But policymakers remain over-reliant on econometric models that are being rendered useless by defiantly strong employment and incomes. Fiscal measures such as higher minimum wages, inflation index-linked pensions and benefits are undermining efforts to control private-sector inflation via interest rates. The answer lies in fiscal policy restraint, not blunt monetary tools.
Central bankers are too fixated on 2% inflation targets. Such precision isn’t useful in an economic system that has been subjected to a sequence of pandemic-inspired lockdowns followed by relentless monetary and fiscal stimulus. Inflationary impulses are starting to wash out of the system, so more flexibility is needed. And there’s precedent: The Fed adopted Flexible Average Inflation Targeting in 2020. but dropped it when the pandemic hit.
The UK situation feels particularly acute. The futures market anticipates the Bank of England rate will peak at 6.3%, compared with 5.6% for the Fed and just over 4% for the ECB. But as Mark Dowding, who oversees $111 billion as chief investment officer of RBC Bluebay Asset Management LLP, said on Tuesday, “If you go too hard you’ll crater the housing market and you’ll end up with a financial crisis in the UK and stagflation.”
Central banks have a duty of care to ensure the poorest in society don’t suffer disproportionately from an entirely avoidable recession. Andy Haldane, former BOE chief economist, argued this week in a Financial Times article that the UK central bank should tolerate above-target inflation and avoid overdosing the economy, shedding the herd mentality of seeing "no alternative" to hiking rates further.
The BOE’s stick is being wielded against the 30% of owner-occupied households with mortgages, while homeowners without debt probably benefit from higher rates. Analysts at Jefferies Financial Group Inc. reckon the burden of rising rates is manageable for the top 40% of earners who hold three-quarters of mortgage debt. So even if all mortgages reprice to 6% they expect no knock-on impact on total discretionary spending. However, the biggest risk to this scenario is a sharp rise in unemployment — the very condition the BOE seems determined to engineer to re-attain its precious 2% inflation target.
Higher interest rates are magnifying inequality. The Office for National Statistics estimates that the UK has a savings cushion of 10% of gross domestic product, worth £340 billion ($430 billion) after surging during the pandemic. For savers and pensioners, after a decade of nugatory yields, having a risk-free income approaching 5% is a godsend. Private-sector wage increases of more than 7% also soften the impact for higher earners.
Central bankers caught out by the surge in inflation are willfully ignoring the fact that the tightening implemented so far will take time to have an impact. In their zeal to curb consumer prices, they risk compounding the felony of misreading the outlook by hammering the economy into recession with the blunt instrument of interest rates. It’s time for a rethink.
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