COLM MCGRATH, Managing Director, Surety Bonds, writes that the world’s central banks are walking a wobbly tightrope as they try to maintain economic stability.
The war in Ukraine, the crazy ‘Trussonomics’ scenario in the UK, China’s zero-Covid policy and US mid-term elections are just the tip of the iceberg. The world today seems, to me, absolutely bonkers and makes it very difficult to see a clear path ahead. In my most recent article in Irish Construction News, I wrote that inflation in Ireland, Europe and the US while running at record levels. Recent figures the European Central Bank [ECB] forecast year-end annual inflation of 8.1%, down from 10.7% with the Federal Reserve [Fed] predicting annual inflation of 7.7% compared to 8.2%) suggest that it has peaked and is decelerating due to aggressive interest rate hikes by the Fed and the ECB. This seems to be the case based on recent reports by both parties and independent economists.
The holy grail of inflation
While there is or was a need to increase interest rates to battle inflation, my concern is whether central banks globally are overtightening, in particular, the ECB and the Fed, in their attempts to get to the holy grail of the 2% target in such an aggressive manner, is causing economic damage. The ECB’s and we could conclude the US’s primary objectives are to maintain price stability, ultimately preserving the purchasing power of their currencies. In fairness, price stability does create conditions for more stable economic growth and a more stable financial system, but I would argue this would apply under more normalised conditions.
Blackrock Investments opinion: “Bringing inflation down to 2% targets will mean significant economic damage, in our view. Why? There’s constrained production capacity in developed economies. The labour market and consumer spending patterns in developed economies have not fully normalized. The result: a mismatch in supply and demand, particularly in the services sector.”
In Ireland, this impacts even more so on the construction sector; demand remains dramatically high while supply is low and reducing.
The Irish Times headline ‘Construction activity shrinks amid cost concerns’ highlights that residential units being developed are down 10%, driven by a drop in apartment starts. Two main factors driving this reduction are cost uncertainty, as material and labour costs remain volatile, and the unpredictable nature of funding, which has been driven by the movement of institutional investors to change their investment strategies.
Dealing with a volatile world
The holy grail of 2% inflation, which is optimum for a balanced economy, is not possible in the current uncertain and volatile world we live in. The current thinking by central banks of fast and furious interest rate hikes is to crush demand, reducing employment, which in turn should reduce inflation, but the downside may cause a recession.
The medium- to short-term goals should be more balanced. A levelling off, lower increases, or a halt to increasing interest rates is paramount. We need to see if these hikes have already taken hold as further increases, particularly high rate raises, could unintentionally push the globe into a much more protracted recession than is required. If this were to happen, then this would leave central banks with very little ammunition to rectify the situation, such as reducing interest rates and reverting to quantitative easing to counteract such a problem.
A protracted recession with depleted central bank arsenals leaves highly indebted countries open to the debt markets. Government bonds start to become too expensive, leaving these countries struggling to refinance their ongoing debt needs. On top of this, we could also see a period of stagflation, “The danger of stagflation is considerable today,” the World Bank warned this week. “Several years of above-average inflation and below-average growth are now likely.”
Economic slowdown and increased unemployment with consistent high inflation are all down to timing effects of monetary policy, while so many other elements are outside of central banks’ control, such as the bottlenecks of increased pricing of gas, ongoing supply shortages in construction, chip manufacturing, labour, etc, driving up costs.
Could we be looking at another 1970’s type of shock, whereby high-interest rates caused a major recession followed by country debt crises? I hope not. The thinking is that central banks have actioned solutions much quicker this time around. However, the tightrope they are walking now is wobbly; let’s hope they can maintain their balance.
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