Central banks around the world are caught in a sizeable dilemma of their own making. First, they left the quantitative floodgates open too widely and for too long; next, they suggested that inflation would only be a temporary issue. Now all that remains is to opt for either inflation or a hefty recession – like choosing between the plague and cholera. At present, inflation is so high in both the USA and the eurozone that the Fed and ECB have no option but to keep taking decisive action to curb it if they wish to preserve any of their reputation as monetary policymakers.
Alexander Raviol, Partner, CIO Alternative Solutions
These days, market players are once again transfixed by the latest rate decisions being made on both sides of the Atlantic. As inflation in the eurozone climbs to record highs, it seems inevitable that the ECB will lift interest rates by another 75 basis points in its meeting at the end of October, which would take the eurozone base rate to 2 percent. Investors also expect the Fed to hike interest rates by a substantial 0.75 percentage points to 4 percent in early November.
This reaction from central banks is long overdue.
Nevertheless, interest rate increases are still manageable compared to inflation. At just over zero percent, the eurozone’s current money market rates seem like a joke compared to the latest 10 percent rise in consumer prices. This hesitancy on the part of central banks has put them in an extremely difficult position. To fulfil their primary role of ensuring price stability, they are being forced to tackle inflation by raising interest rates, despite the fact that such a move will only fuel the recession currently looming on both sides of the Atlantic.
Central banks waited too long to crack down on record levels of inflation. Now the eurozone is hurtling towards recession – never a good time to act decisively against sharp price increases.
The landscape has changed.
Over the last few years and decades, central banks have been able to print money and avoid recessions while keeping inflation in the capital markets to a minimum. With the conditions for years of low interest rates fast disappearing, those days are gone. Deglobalisation, the relocation of production processes, geopolitical shifts triggered by the war in Ukraine, structural energy price rises and, last but not least, excessive government spending and rising global debt levels are all combining to drive inflation higher.
In this environment, it seems likely that only a severe recession will enable us to get to grips with inflation.
This is the only way to iron out the imbalances created by excessively loose monetary policy. Yet the recession we are talking about here could prove to be more intense than anything we have witnessed in recent decades. The recession triggered by Paul Volcker when he opted to tackle inflation by raising interest rates to 20 percent during his time as Fed president forty years ago would seem harmless by comparison. And in any event, current government debt levels would render such an approach virtually impossible. Our economy would fall into recession even with much lower interest rates, and of course, nobody wants that.
What is the most likely scenario?
Although central banks are asserting that they will take resolute action to tackle inflation, there is a significant chance that this resolve will crumble as soon as there are clearer indications of either a deep recession or serious upheaval within the financial system, even if this means accepting that inflation will remain high.
The turbulence in the United Kingdom and the Bank of England’s reaction to it in late September showed how quickly monetary authorities can abandon their good intentions when the going gets tough. But what exactly happened? The sharp rise in borrowing rates on long-dated government bonds put pension funds and insurance companies in the UK under serious strain. This turbulence forced several providers to liquidate positions in order to fund margin calls on various derivatives strategies. The only firefighting option left to the Bank of England was to go back to the buy side to slow down the rise in interest rates at the long end of the market instead of selling bonds from its balance sheet as originally planned.
Inflation isn’t all about downside...
With all this in mind, there is still one point that central bankers would prefer not to admit openly: namely, that inflation has major benefits for the countries it affects, as it allows high levels of debt to be maintained or even increased further. Around the world, government spending and budget deficits are rising ever faster, which can only be achieved by taking on more debt. An excessively restrictive central bank policy is undesirable when travelling down this path. Anyone wishing to refute this argument would have to be an exceptionally staunch advocate of the theory that central banks act completely independently.
We need to get used to the idea that inflation is here to stay.
What’s more, it will stick around at a much higher level on average than anything we have seen over the past few decades. At the same time, real economic growth is more likely to stagnate than increase. All of this means we will see a decline in prosperity, with wealth set to shrink in real terms over the next few years.
What does this mean for investors?
The 1970s showed that, despite their ambitious valuations, tangible assets such as equities represent a viable long-term alternative in times of high inflation and negative real interest rates. This remains the case even when volatility is repeatedly increased by considerable uncertainty in the capital markets. Anyone willing to withstand these fluctuations in the equity markets can invest anticyclically by diversifying their investments more broadly and making the most of buying opportunities. Anyone unable or unwilling to tolerate significant drawdowns should consider integrating capital protection concepts into their strategy. In any event, staying away from the equity market altogether is not a reasonable option for investors.