Top 5 Questions being asked today
1. Why are markets so volatile?
We have discussed at length the challenges of Covid 19 and the Ukraine war facing the global economy. These inflationary forces have driven inflation well above central bank targets. Inflation reached a new 40-year peak in the US in May. Australian inflation sits well above the 3% upper target. And the Reserve Bank of Australia expects it to move higher.
High inflation has left central banks scrambling to reverse ultra-accommodative monetary policy. Rate hikes under way in the US and Australia. Markets now expect the policy rate to be close to 4% by year-end in both economies. That is a very rapid increase from the start of 2022, where rates were just 0.1% and 0.25% in Australia and the US respectively (Chart 1).
2. How high can interest rates go?
Rate hikes will impact inflation through demand, wages and house prices. Central banks want to lean against this type of inflation. They have limited control over supply side inflation – the rise in food, commodities and energy as a result of Covid19 and the Ukraine war.
Rate hikes also operate with a lag. This can be between 6 and 24 months. Central banks will want to hike enough to ensure they are controlling inflationary pressure through 2023, but not so much they cause a recession. Rates will go higher than the 0.85% and 1.00% currently in Australia and the US. But we think they will not go so high as the markets have predicted this year.
3. What is the risk of a global recession and/or one here in Australia?
There is a very narrow landing strip for central banks to achieve a “soft landing”. Central banks have almost always caused a recession when they hike rates. But it is possible to achieve a soft-landing for a period of time. A soft landing would involve:
rates moving higher, albeit less than markets are pricing,
inflation moving back towards central bank targets, around 2.5%,
growth slowing to around trend, and
jobs growth slowing from elevated levels.
The most likely alternative scenario is a hard landing. A hard landing would cause a recession over the next 18 months. A hard landing is a scenario where:
rates move above market expectations,
inflation remains elevated for a period of time,
growth falls below trend, and
the unemployment rate moves higher from current low levels.
The 20% decline in equities is a signal that investors currently expect around a 50% chance of a recession over the next 18 months. We think that probability is too high. The US economy remains robust. Banks and households have repaired their balance sheets. Jobs growth is strong. In Australia, the economy is enjoying a strong terms of trade boost thanks to elevated commodity prices. The unemployment rate is at historic lows. We think both economies are some way off a recession.