Monetary Tightening

Most major central banks around the world have been tightening their monetary policy this year, with the Reserve Bank of New Zealand (RBNZ) and the Bank of England (BoE) having kicked-off their rate hiking cycles even earlier - in October and December of 2021 respectively. The Bank of Japan is a notable exception, since it still employees ultra-loose policies.

They have undertaken this action in order to combat surging inflation, which has hit multi-decade - even record - highs in most major economies. This is largely a result of the post-pandemic recovery and the relevant extraordinary monetary and fiscal stimulus, which was aggravated by the war in Ukraine, the ensuing rally in energy and commodity prices, as well as trade disruptions.

Delayed Action

However, most central banks, including the US Fed, had for a long time overlooked rising prices, viewing them as "transitory". Chair Powell was forced to retire the term around a year ago ^[1] and make fighting inflation the top priority, leading the bank to a policy shift.

As such, bank official have drawn criticism for acting too late, with the European Central Bank for example, only lifting rates as recently as July. Furthermore, this process started in a very conservative way for most central banks, with small increases in interest rates.

This has proven ineffective so far, since inflationary pressures have persisted, forcing them to far more aggressive action over the last few months, with unprecedented moves on rates. One also
has to take into account, that the rise in inflation is mostly driven by the supply side, over which CBs have no control, since they can only influence demand.

Recession Fears

Monetary tightening has an adverse impact on the economy, along with factors such as continuing supply chain disruptions, the energy crisis to which Euorozone is particularly vulnerable and more.
We are clearly in a stagflationary environment, since there is a slowdown in economic activity, while inflation remains elevated, but an outright recession has not yet materialized.

However, some countries expect this to happen soon, while the World Bank recently alluded to the negative impact of current monetary policies, noting that "As central banks across the world simultaneously hike interest rates in response to inflation, the world may be edging toward a global recession in 2023". ^[2]

Furthermore, the US economy contracted in Q1 and Q2 (preliminary data), with two consecutive quarters of negative growth, generally considered a recession. The Fed however, has largely dismissed that, pointing mainly to the strong labor market.

Policy Mistake?

Central bank activity has so far failed to control inflation and now the economic slowdown puts them in a bind, since these two forces pull monetary policy in opposite directions. This is evident in their communication and forward guidance, which has become a messy affair.

Having lost credibility with their delayed and initially conservative reaction, policy makers have chosen to reemphasize their commitment on restoring price stability as of late. In line with this, they have pushed the envelope with more aggressive and historic rate hikes recently.

This increases the chances of a policy mistake, meaning that they may go too far, harming the labor market and plunging the economy into a recession. This progression of monetary policy does not inspire much confidence in their ability to devise a soft landing, and it does feel like they me misjudging prospects of a recession, same way the misjudged inflation.

However, given the fact that price stability is general viewed as the bedrock of any economy, they may have no other choice but to hike forcefully and rapidly in order to avoid and deanchoring of inflation expectations.

Despite current resolve to bring down inflation, priorities change and we don't know how policy makers will react if down the road unemployment and economic performance deteriorate and start becoming more pronounced problems.

Recent Central Bank Activity

During the current week, we had some intense central banking activity, as many banks delivered historic decision. The Fed was the main focal point, but more banks made the headlines, such the Banks of England and the Swiss National Bank.

US Fed

The US Federal delivered its third straight 0.75% hike on Wednesday, in the most aggressive tightening cycle in at least three decades. It also upgraded its projected policy path, expecting media rate at 4.4% by the end of the year and 4.6% by 2023.

Moreover, it seems to have given up on the effort to achieve a soft landing, with Chair Powell acknowledging that no one knows if the current tightening "will lead to a recession and if so how significant that recession would be".^[3]

Bank of England

The BoE had a golden opportunity to get ahead of inflation, since it began its hike cycle almost a year ago, though it was restrained to timid increments of no more than 0.25%. As this strategy failed and the cost of living remains high, it was forced to break with convention last month and increase rates by 50 basis points, the biggest move since 1995. ^[4]

This Thursday, its doubled down with another 50 bps move, bringing them to 2.75% and highest since November 2008, essentially hiking into a recession – not enviable situation. Officials expect an economic contraction to last until the end of 2023. In a less grim note, they downgraded their inflation forecast yesterday to a peak of just under 11% in October, but still expect to say above 10% over the following months. ^[5]

Swiss National Bank

The SNB turned heads yesterday since it took rates out of negative territory, for the first time in eight years. It raised them by 75 basis points, to 0.5%, which the highest level since 2008. ^[6]

It did so in order to counteract "the renewed rise in inflationary pressure and the spread of inflation to goods and services", while policy makers left the door open to further rate increases.

The central bank now expects GDP growth of around 2% this year, which quite robust, but marks a stark downgrade from the previous projection.

Bank of Japan

The BoJ is an entirely different phase, since it employees an uber-loose monetary policy strategy, which includes yield curve control, often taping into the bond market keep yields around zero ^[7]. All this, despite the fact that inflation has been running above the 2% target for quite a few months.

This week, it maintained its dovish stance and got further isolated, being now essentially the only major bank with negative rates (-0.1%). During his press conference, governor Kuroba pressed on the dovish messaging, saying that "There's absolutely no change to our stance of maintaining easy monetary policy for the time being. We won't be raising interest rates for the time being", according to Reuters ^[8].

This policy has of course been a sourceof great weakness for the Yen, with USD/JPY hitting fresh high this week. Because of this and in completely opposite direction of the BoJ policy stance, Japanese authorities were forced to intervene in the FX market to support the flailing currency. ^[9]

European Central Bank

After July's aggressive lift-off, the ECB hiked rates by a historic 75 basis points earlier in the month and pointed to more tightening ahead, stating that "over the next several meetings we expect to raise interest rates further to dampen demand and guard against the risk of a persistent upward shift in inflation expectations".^[10]

Officials took this action, despite the fact that they expect the economy "to stagnate later in the year and in the first quarter of 2023" and potentially contracting next year in case of "more severe disruptions to European energy supplies".^[11]