Inflation beaten or pause in interest rate rises to avoid recession?

Rapid rise in interest rates, inflation and public debt

At its recent meeting, the IMF expressed concern about inflation and the amount of debt that governments have accumulated and the growth in debt servicing costs in a context of rising interest rates. The 10-year US Treasury bond is at its highest level since 2008, and this is just one example, as many other governments are in this zone of rapidly rising interest rates and high level of debt.

Will real estate come back to haunt us? 

Some of China’s behemoths have already had to reschedule interest payments and repayments.  After mortgage rates have risen by several percentage points, what will become of the consumer’s ability to pay and consume?

And then there’s politics and wars

The geopolitical context is becoming increasingly tense.  What will happen in Ukraine and the Middle East?  What will happen to supply chains?

And we thought exchange rates were volatile…

Of course, exchange rates are inherently unpredictable, but in this context it’s even more obvious that any prediction about them is the last thing on which business decisions should be based.  At most, the forecast can become the starting point for an exchange rate scenario in D-Risk FX, or a conversation with our team to help you reduce the risks associated with your international business operations.

The safe-haven effect

The upward cycle in central bank interest rates is nearing its end.  Higher US interest rates and the US dollar’s safe-haven status strengthened it against (almost) all other currencies in the recent months.

Over the past quarter, the currency market has been trying to anticipate the level of interest rates at which central banks feel they have done what is necessary to counteract inflation.

In short, the US dollar strengthened relentlessly

In fact, the EUR/USD fell quietly without much of a jolt over the quarter (1 EUR: 1.09 USD to 1.057 USD).  The British pound followed the same slow, long downward trend (1 GBP = 1.31 USD to 1.21USD).

The Canadian dollar (CAD) also followed this path, but with more jolts (from 1 CAD = 0.76 USD to 0.73 USD), while the Mexican PESO (MXN) went from 1 USD =16.5 MXN to 18.25 MXN.  In Asia, the Japanese YEN also lost ground to the USD (1 YEN = 0.00725 USD to 0.0066 USD).

Central banks

Except for the European Central Bank, which raised its key rate to 4.5%, the Bank of England (5.25%), the US Fed (5.5%) and the Canadian Central Bank (5.25%) maintained their key rates at their last respective meetings.

The results of the various central bank meetings to come, and the economic data published on the main financial markets, will be closely scrutinized, and could rapidly alter this status quo.

Already, in the wake of rising consumer prices, Japan’s central bank surprised the market last week by raising the yield ceiling on 10-year bonds from 0.25% to 0.5%.  Mortgage rates have risen, reflecting the Bank of Japan’s shift away from its highly accommodating policy.

And inflation, beaten or still biting?

Germany saw a drop in inflation. It fell below 6%, a first since the invasion of Ukraine. Italy and France are holding steady at around 5%.  Globally, the trend is also in the right direction, with European inflation over 12 months down from over 10% to just under 4%.  Inflation in the UK also fell over 12 months, from over 11% to 6.7%.  It remains, however, the highest in Europe, and is falling less rapidly than its European partners.In the United States, inflation (3.7%) accelerated slightly in line with consumer spending at the end of the third quarter, although ex-food and energy inflation was slightly down. The FED expects inflation to return to its 2% target over the next few months.

In Canada, after rising from 2.8% in June to 4% in August, inflation stood at 3.8% in September.  An encouraging drop following the upward cycle in interest rates initiated by the Bank of Canada. The Bank has indicated that it will continue its policy of quantitative tightening for the time being.

However, these levels are still two to three times the 2% target set by most central banks. Further interest rate hikes are likely.

What about the economy?

The US economy is proving stronger, while China’s is weaker than expected. European growth has slowed further. Overall, inflation is falling in most economies as supply chain bottlenecks ease and rising interest-rate-induced demand eases price pressures.

However, central banks will be watching for persistent inflation. The descent must continue, or interest rates will rise.  Overall, the economy has adjusted to previous rate hikes without showing too many signs of a pronounced slowdown. If this recent surge in interest rates is sufficient, the “soft landing” hypothesis becomes realistic.  However, if inflation persists and interest rates rise again, the resilience of the economy will be severely tested in the months ahead.

Although recent data are positive for the economic outlook, the recent outbreak of violence in the Middle East presents a downside risk to growth and a strong risk of higher inflation.

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