Weekly Update - Central banks toughen tone; financial markets shake
A week dominated by increasingly hawkish central bank statements. The ECB set the tone, surprising the markets by pre-announcing the start of a series of interest rate rises and the end of all asset purchase programmes. The Federal Reserve then raised its Funds rate by an unexpected 75 bp – its biggest single hike for more than 28 years. The Bank of England followed suit with a more predictable 25 bp base rate rise and has now tightened policy by 125 points since December. Finally, even the Swiss National Bank pitched in, raising its policy rate 50 bp this week. This string of announcements triggered a major correction in all financial markets. Bond markets dropped -3% in a week (Bloomberg Global Aggregate Index) in the wake of the interest rate rises. From 8 June, equity markets joined the retreat, losing 11% in the US and Euro area, 9% in the UK and 6% across emerging markets (MSCI indices) (Chart 1).
Willing to trigger recession? The more hawkish tone struck by central banks raises fears they may be willing to contemplate recession if it will ultimately rein in inflation. There is no doubt they are increasingly worried about inflation. The adjective “transitory” has been dropped following successive shocks that show no sign of abating. Monetary authorities see economies holding up despite these shocks and worry that price pressures may lock in. It would now take a major fall in the inflation figures to stay in their hand. Short term, we could see such a fall if oil prices drop, but this is hard to imagine in the new geopolitical environment. A real easing of pressure on production chains could have the same effect, but this looks equally unlikely, particularly as Chinese lockdowns continue to drag on. The last solution would be a decline in global demand, and this could be deliberately engineered by tightening monetary policy. This is the recession scenario which markets are now pricing in.
Financial stability at risk. The rise in interest rates is worrying not only because of its effect on the economy but also because it might impact financial stability. The Covid crisis led to a fresh surge in levels of indebtedness. True, there was also an expansion of liquidity which should limit the risks, at least in the short term. But some classes of economic agents could soon find themselves in trouble. As we saw with the heavy pressure on Euro area sovereign debt markets this week (Chart 2). On this occasion, the ECB came out all guns blazing to deal with the problem, but situations may arise where this is not the case.
Also, in the main events of the week, we chose to talk about fragmentation fears in the Euro area and about the tightening of the Swiss monetary policy.