Rates and Recessions Everywhere

It must have been “Central Banker Day” in a few countries recently. It’s like Groundhog Day but where central bankers come out into public and we can tell from their behavior whether it’s another year of inflation or not.

The European Central Bank

Last week the ECB raised its policy rate by 0.75% bringing the policy rate to 1.5%. This was the second time in a row it raised rates that much and 0.75% is the largest increase since its founding in 1999[1]. That is to say, it’s a lot and twice in a row is a lot.

Christine Lagarde, Chair of the ECB, then made headlines again this week when she said she sees a (likely) mild recession in Europe next year but that it wouldn’t be sufficient to tame inflation.  She continued by saying that price stability is the ECB’s job and they would get it under control.  Inflation in Europe remains at 10.7%, the highest in ECB history and more than five times its 2% inflation target.

The implications of her comments were not missed.  Everyone heard and correctly understood Chair Lagarde as saying, We have a serious inflation problem. It is the primary challenge facing the ECB. Our mandate is to maintain stable prices. We will fix this. But the timing is really bad because the European economy will enter a recession next year and we will, unfortunately, have to continue raising interest rates anyway, adding to the pain. Sorry[2].

An alternative reading is this: Sorry. We should have started doing our job a year ago. We didn’t. Now it means double the pain for you all.  That really sucks, but you’re on your own.

Finally, it’s worth noting that the ECB said it would continue to shrink its portfolio of approx. $5 trillion in bonds that it bought doing quantitative easing in recent years.  I’ll come back to this last point.

The US Federal Reserve Bank

On Wednesday this week, the US Fed’s Federal Open Market Committee (FOMC), met and agreed to raise the US rates by .75% as well, pushing our policy rate up to about 4%.  The US will also likely be in a recession in 2023 although it’s not clear what that means.  GDP growth this year has basically been zero, but labor markets keep producing unemployment around 3.6% which is historically low.  These are strange economic times.

The Fed’s statement started by acknowledging its dual mandate “[t]he Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run”. 

Then it explained that “[t]he Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” And it reiterated that “[t]he Committee is strongly committed to returning inflation to its 2 percent objective.”[3]

Jerome Powell, the US Fed Chair, added some flavor to this in his press conference. In particular, he emphasized that the Fed is focused on getting inflation back to its 2% target and recent inflation numbers have continued to “be higher than expected” so the Fed will have to fight harder.   Of course that begs the question of why the Fed keeps getting wrong it’s own forecasts of the one thing it’s supposed to be able to control over time, inflation. But let’s move on.

While never using the word recession, Powell said that the Fed recognized that the economy is slowing, consumer purchases are slowing, and financial conditions are tightening but unemployment is low (i.e., employment is strong suggesting the economy is still strong).  He explained that reducing inflation is likely to require a “sustained period of below trend growth and some softening of labor market conditions”.  Below trend means recession in econ-talk.  So the interpretation of this is: We will fight inflation and it will cause a recession.

He reiterated that “historical precedent” cautions strongly against stopping the inflation fight too soon. And he added, “we will stay the course until the job is done”.  That was all referencing one of the key lessons of the 1970s.  

In the 1970s the Fed raised rates, the economy slowed and inflation fell some, so the Fed then lowered rates to avoid a recession which led to more inflation which the Fed then tried to fight, but when the economy slowed again, it backtracked leading to more inflation again and so on. This was an out-of-balance pendulum that swung back and forth but continued swinging more toward inflation and less growth every time.  Eventually the result was just stagflation (a recession and high inflation together).  The best analogy is drinking to cure a hangover. Yes it works at first, but less and less well over time until eventually you have a hangover (recession) and you’re drunk (inflation) as well as probably struggling with a host of other issues (banking problems, exchange rate issues, government finance problems, etc.).

As I’ve mentioned in previous columns[4], the Fed is worried about long-run inflation expectations.  Chairs Powell and Lagarde both spoke to this directly. Both central bank chairs explained that inflation is high, but it’s also very important to recognize that it’s been high for a while. That’s a problem because, if it persists, people will expect it to remain high. That is, long run inflation expectations will become unanchored and then all hell will break loose, inflation will rise further and it will definitely be harder and more painful to stop.

The reason is? When everyone expects inflation to be, say 10%, next year, then we all ask for a 10% raise today and businesses start to agree because they know they’ll pass it on in higher sales prices (10%) as well.  We get 10% more money which we also spend, pushing prices up across the economy. If instead, no one believes it will be 10% next year, but back to 2-3%, we’ll ask for less, businesses will resist as much as possible and inflation won’t rise as much.  That’s all very painful, by the way, but at least it’s not perpetuating the inflation cycle.

Powell also made me laugh because he said that he thinks the Fed still has credibility and has anchored long-run inflation expectations. To explain why he believes that he said “just look at consumer expectations and market forecasts” which all forecast low inflation next year.  I think this is “bunk”, to be polite.  As I’ve argued elsewhere and made fun of in previous columns[5] every forecast in every country from the US to Turkey to Argentina predicts inflation will drop like a rock next year.  That’s reflecting delusion on the part of the forecasters, not Fed credibility.  Or, at best, you can’t conclude that it implies anything about Fed credibility.  These forecasts seem arbitrary, in my opinion.

The message of the FOMC and Chair Powell was also loud and clear: We raised interest rates. We will raise them again. We might not raise them by as much next time, but we are committed to the 2% target. We aren’t even close today and higher interest rates are the way we know how to get inflation down to its target. So that’s what we’ll keep doing, raising interest rates.

As a final note, which I’ll return to, the Fed also said that “the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities”.  That means the Fed too plans to sell some of the bonds and other things that they bought as part of quantitative easing in recent years.

The Bank of England

The British seem determined to give us all the wildest ride imaginable these days. 

On Thursday this week, the Bank of England also announced a rate increase of .75% putting their policy rate at 3%.  But then they proceeded with two potential scenarios which they explained in some detail, suggesting to me that these exact numbers are coming out of a model somewhere and that makes me a little nervous to be honest because I think central bankers are thinking too much of their models these days.  In any case…

• In Scenario One, the BoE raises rates to 5.25% and keep it there until inflation hits zero three years from now.  The economic impact of that policy, however, will be an eight quarter recession which will make it the longest recession in the UK since WWII.

• In Scenario Two, the BoE holds rates around the current 3% level. Inflation, currently 10.9% in the UK then falls slowly next year to 5.6% , then to 2.2%in 2024 and to less than 2% in 2025.  This still leads to a recession, but only for five quarters.

The BoE additionally announced that it will continue selling bonds it bought as part of its quantitative easing program as well.

And one, final note. The BoE also started it’s policy statement with this: “We are increasing Bank Rate because inflation is too high. And it is the Bank’s job to bring it down.”[6]  It’s interesting to me that all the central banks essentially made this statemen somewhere. (1) Inflation is high. (2) We take responsibility.  I guess it’s good. It’s at least better than them denying responsibility but I think they include it to justify the pain they are imposing and about to propose. They are very worried about their credibility and it shows.

In other news…

In other news, Maersk, the global shipping company announced that it expects demand to have dropped a total of 2-4% in 2022.    Maersk is a huge company and rents the containers that go on ships all over the world. 

This -2 to -4% is “up” from the initial estimate of -1% for the year.  That tells us a lot.  To start, it tells us that the end of the year is looking bad.  Until now they were thinking -1% but now that they see Q3 and orders in Q4 pretty clearly its -2 to -4%.  That’s a hard ending to the year.

Secondly, the Maersk news, combined with what we’re hearing from the central banks in various countries, tells us that the slowdown is widespread and across a range of industries. If that weren’t the case, you’d have expected Maersk to say something like we see -1% overall, but are realizing the X or Y sector will be down a lot more. But no. They say -2 to -4% generally. That includes a wide range of industries from food to toys to patio furniture to automobiles and a million other things.

Initial Thoughts

The central banks and private businesses clearly see a recession.  And the banks all see that, despite the recession, they will all be raising interest rates.  That means, 2024 is going to be a hard year.  Full stop. Let that sink in.

We’ll likely be in a stagflationary environment where we have high inflation and high unemployment, combined with high interest rates.  That’s going to be rough.  For most of us, that’s the biggest message. 2024 is going to be hard.

The good news - if we want to insist on a silver lining here - is that all the central banks seem convinced that they will also manage to get inflation down.  So, painful, yes. But, inflation will finally be conquered.

How do we get there?

The puzzling piece as an economist is how central banks think we’ll get to low inflation.

First of all, they all plan to sell bonds.  Let me explain why I care. Imagine you walk into a store and buy something with cash and walk out.  Now you have something in your hand (whatever you bought) and you left cash in the store with the clerk.  When the central bank enters the private markets (like the store), it sells something (a bond) and walks out with cash. In that case, it removed cash from the market and left a bond.  This reduces the amount of money (“cash”) in the economy.  Traditionally, economists thought this exchange is what left too many dollars chasing too few goods (i.e., “inflation”) or too few dollars chasing the goods (i.e., “deflation” when they sell bonds).  Today we are told that monetary policy doesn’t work that way anymore.  Yet every central bank is doing it.

In fairness, they will explain that they are trading longer-term assets and trying to affect longer-term interest rates. They will also say they are doing it to restrict liquidity in financial institutions, tightening their belts so they pass on the tightening to businesses and consumers, restricting demand overall.  That, they believe, eventually lowers inflation. (To my fellow economists: How is that really different from the old monetarist story of putting more or less money into private hands via open market operations?).

Second, the US Fed generally and Chair Powell’s statement specifically argue that policy is more about the level of the interest rate now. Powell said “we will have to raise the policy rate to a higher level than we previously thought and hold it there”.  That’s the only way to stamp out inflation.  They think 5% or so is right and then they can just hold it there until inflation really falls.

The ECB, however, is just getting off the ground now with rates near 1.5%. They forecast rates at 3% by the end of 2023. Clearly the ECB doesn’t believe it needs 5% interest rates.

The BoE believes it could do 5%, hold it and inflation would fall to zero over three years. Or it could set it at 3%, hold it and inflation would fall to 2% (or less) over three years.

All these rates are nominal and the real rates are negative.  The real rate is the nominal minus inflation.  So, in the EU, inflation is 10% and nominal rates are 2% so the real rate is -8%.  In England, inflation is 10% and the nominal is 3% so real rates are -7%. In the US inflation is 8% and rates are 4%, so real rates are -4%.  Normally monetary economists would tell you that NEGATIVE real rates are stimulating the economy and likely driving inflation higher, not lower.

In all the cases, the projections includes a recession.  But Chair Lagarde of the ECB says that the recession won’t be enough to get inflation down. So the (negative) interest rates and bond sales must also be doing the heavy lifting to fight inflation.

I’ve said this before and will surely say it again, but I do not think we in the monetary economics profession – including central bankers – fully understand what determines inflation anymore.  It’s troubling.

Sit and watch

We all have to live through this mess. It’s expensive. It’s costly. It screws up everyone’s plans, their retirement accounts, their grocery versus home heating versus gasoline budgets and so on. And that pain is worse and worse the further down the income ladder you go.  Inflation is a cruel and very regressive tax.  Add to that higher interest rates, slower growth, less jobs and losing jobs and you have a recipe for real hardship. 

Again, all those things are hardest on those least likely to bear them.  So on a personal note, watch out for neighbors. Keep an eye on your relatives who might have a little less than you do. They might need help and not want to admit it.  This will be hard and if you can help someone, I believe personally that you should.

And you can and should be mad at monetary and fiscal policymakers for this.  They were irresponsible for too long in all these countries and in most others around the world.  At the very least, every one of these central banks saw inflation coming last year and kept their feet on the gas pedal anyway. Shame on them. They know better.  It did not have to be this bad.

As an economist, this is going to be a fascinating and twisted experiment.  Will inflation fall differently in countries that hold interest rates at 3% versus those that hold at 5%?  Will it depend on who sells more bonds?  Will we ever be able to untangle whether it was the higher interest rates or the bond sales reducing money that lowered inflation?

And anyone trading, it will be a wild ride.  Some stocks will fall, others rise as industries are affected differently. Currencies will move sharply against each other as future inflation expectations shift across countries and rates rise and fall at different rates.

It’s going to be interesting. Buckle in.

Correction: The initial version of this had a typo stating the BoE raised rates by .5%. That has been corrected to .75%.

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[1]  Funny enough, it raised it by exactly .75 points at one of it’s first meetings, then reversed it a few weeks later. They opened the Euro on January 1, 1999, and set interest rates at 2%, then raised them to 2.75 on January 4th and put them back to 2% on January 22nd.  Since then, they haven’t raised rates by that much until now.

[2]   Throughout I use italics for my imaginary language/interpretation from them. I first used quotations but then it’s confusing what’s a real quote and what’s me putting words in their mouth. Italics are me putting words in their mouths. Quotes are actual statements and phrases they used.

[3]   You can find the official statement here: https://www.federalreserve.gov/newsevents/pressreleases/monetary20221102a.htm It’s only a few paragraphs, probably not even a whole page.

[4] 

The Fed Has No Clothes

[5] 

Fun with Inflation Expectations

[6]  https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy-report/2022/november/opening-remarks-november-2022.pdf