Key Questions: Will Actions by Global Central Banks Lead to a Recession?

Rajeev Sharma, Managing Director of Fixed Income, KeyBank Investment Center

<p>Key Questions:&nbsp;Will Actions by Global Central Banks Lead to a Recession?</p>

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Central banks face a dilemma: Allow inflation to remain persistent or raise interest rates to combat it at the potential cost of a serious global economic slowdown.

The US Federal Reserve (the Fed) showed its resolve to fight inflation by raising rates 75 basis points (0.75%) last week – its biggest rate hike since 1994. The Bank of England also hiked rates 25 basis points, pushing the cost of borrowing to its highest level since 2009. The Swiss National Bank surprised investors last week by raising interest rates for the first time in 15 years by 50 basis points. And as if to say, “Don’t leave us out,” the European Central Bank signaled that it, too, will raise rates 25 basis points in July and 50 basis points in September.

All this indicates that central banks are working to tame inflationary pressures by placing a premium on “price stability” (code for low/moderate inflation) versus economic growth. As a result, with a series of continued rate hikes expected, market fears of a global recession have been rekindled.

The rate of inflation in the US and the United Kingdom stands at 8.5% and 9%, respectively, far above the 2% target messaged by the Fed and the Bank of England.

This is the result of years of aggressive fiscal spending combined with quantitative easing and extremely low interest rates leading to cheap and accessible borrowing.

Hiking interest rates will work to reduce the prospect of multi-decade high inflation by increasing the cost of borrowing and, in turn, reducing the amount of spending in the economy.

Economy Still Strong but for How Long?

So far, leading indicators continue to point to a strong economy but concerns of a slowdown are looming. In its recently released Summary of Economic Projections, the Fed downgraded its forecast for real GDP: The US economy is expected to grow 1.7% this year, down from its prior forecast of 2.8% announced at the March Federal Open Market Committee meeting. The projection for 2023 was cut to 1.7%, from the prior forecast of 2.2%. These projections are below the longer-run forecast of 1.8%. In addition, the US unemployment rate forecast was revised higher, reflecting the committee’s gradual move away from its optimistic view that it can raise rates without negatively affecting unemployment.

The European Central Bank revised down Gross Domestic Product growth for 2022, as well. The new figure of 2.8% compares with 3.7% published three months ago. And inflation is projected to be significantly higher this year at 6.8%, up from 5.1% in March.

 

The medium-term outlook for inflation is what matters most for policymakers.

With inflation at current levels, larger swings in price changes are more likely in any given month than when inflation is range bound and stable. This feeds great uncertainty and volatility in the economy. The odds of a soft landing for the economy become increasingly difficult in this aggressive rate-hiking environment. Please refer to our prior Key Questions article “What Could Jay Powell Learn from a WWII Hero?1 to learn more about the term “soft landing” and our views on how one might be achieved.

Driving Up the US Dollar

The hawkish trajectory of the Fed’s monetary policy has been putting pressure on its central bank peers by driving up the US dollar. This has led to depreciation of other nation’s currencies – a byproduct of our integrated global capital markets and further stoking inflationary flames. In addition, the US dollar has been benefiting from rising US bond yields. However, last Thursday’s actions by the Swiss National Bank led to a drop in the US dollar, weighed in part by the Swiss franc, which surged 2.6% for its biggest one-day gain in seven years. The US dollar, on the other hand, fell 0.4%, pulling back from a 20-year high the day before.

World stocks resumed their slide last week and government bonds hovered at multi-year highs after the markets created perspective around central bank actions. After the Fed’s hike of 75 basis points, the MSCI’s gauge of global stocks dropped 2.1%. The Dow Jones Industrial Average fell 2.1%, the S&P 500 slumped 2.8% and the Nasdaq Composite dropped 3.5%.

Global monetary policymakers have laid out an aggressive tightening campaign by embracing interest rate increases of a magnitude unimaginable at the start of the year. The issue is that the central banks are not just behind the curve, they are significantly behind the curve. Inflationary pressures have been more persistent than anticipated as the result of policies imposed to limit the economic impact of COVID-19, global supply chain pressures and the war in Ukraine.

Because of the central banks’ responses, however, the unintended consequences of a rapid move away from easy monetary policy include rising probabilities of a recession, which has unsettled financial markets.

Key Takeaways

We continue to recommend holding safe and highquality assets to ride out continued market turmoil. We encourage investors to remain disciplined and take the steps necessary to ensure that their portfolios are well diversified.

We also believe investors should select and maintain an asset-allocation strategy that can be sustained through a bear market and an economic downturn. Today’s headwinds are swift, but they will subside once policymakers pivot again. To wit: Within its own forecast, after raising interest rates significantly in 2022 and 2023, the Fed projects interest rates will come down in 2024. Between now and then, the ride may be a bumpy one. But long-term investors should be rewarded for their patience and discipline.

For more information, please contact your advisor.


Rajeev Sharma Biopic

About Rajeev Sharma

Rajeev Sharma is Managing Director of Fixed Income Investments at Key Private Bank. In this role, Rajeev is responsible for overseeing and managing Taxable and Tax-exempt Fixed Income investments, including common trust funds, institutional model strategies and individual fixed income portfolios for both institutional and high-net-worth clients.

Rajeev has 20 years of Fixed Income experience. Prior to joining KeyBank, he was Head of Fixed income at Foresters Investment Management Company. He served as the chief corporate bond strategist and lead portfolio manager responsible for all corporate bond exposure across the mutual fund and life insurance suite of products. As Director of Fixed Income and overseeing managed fixed income and money market funds he was instrumental in launching a short duration bond strategy, co-manager on the Limited Duration Bond Fund, and the Total Return Fund, a mixed asset allocation fund.

Rajeev also brings prior experience as senior credit analyst at Lazard Asset Management, and associate director of corporate ratings at Standard & Poor’s Rating Services.

Rajeev received his Bachelor of Science degree in Electrical Engineering from Drexel University, a Master of Science degree in Electrical Engineering from the University of Pennsylvania, and an MBA from Cornell University.

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Please refer to our prior Key Question article “What Could Jay Powell Learn from a WWII Hero?” to learn more about the term “soft landing” and our views on how one might be achieved.

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