Growth or Inflation – The Central Banks’ Dilemma

It’s the age-old debate, but never has it been more prevalent. Should central banks continue to focus on taming inflation, or is it time for policy makers to take their foot of the tightening pedal to prevent the major economies of the world sliding into recession?

Last week, my colleague Kambiz Kazemi wrote a piece titled ‘The Fall of Uncertainty’ highlighting the challenge facing the Fed and the odd-looking yield curve, which suggests the possibility of one more hike this year, ahead of rate cuts in Spring 2024. Given that economic growth in the world’s largest economy remains remarkably resilient, it seems plausible that the Fed can afford to keep rates higher for longer and prioritise maintaining price stability.

The problem facing the Bank of England (BoE), however, is even more challenging. The economy contracted by a larger than expected 0.5% in July, according to figures released last week. It may not be enough to tip the wider Q3 reading into negative territory when it’s published at the end of the month but, nonetheless, it highlights the precarious position the Monetary Policy Committee (MPC) finds itself in. In the short term, it could be argued that the drop was largely due to industrial strike action which resulted in fewer working days. Such factors should theoretically be one-offs (and therefore are often ignored by economists) but it highlights the fragile nature of the economy.

Meanwhile, inflationary pressures are at risk of rising again amid a sharp rise in energy prices over the past two months. The UK is particularly at risk given its reliance on imported energy, as is much of Europe. Fortunately, a relatively mild winter last year eased pressure on demand and helped prices fall from their highs, but supply cuts have already resulted a 40% rise in Brent prices in recent months and gas prices are following. However, it’s not just energy that’s stoking inflation. In the UK, the labour market remains very tight, and wages continue to rise faster than they have done in decades. Andrew Bailey callously told workers that they shouldn’t be asking for pay rises because it was fuelling inflation and, while his comments weren’t well received by Joe Public, there’s no doubt that rising wages are contributing to higher prices.

Obviously, it doesn’t have to be a case of growth or inflation but, in the current economic climate, central banks need to decide which to prioritise. Pumping money into the system may help avoid a recession, but it will certainly stoke inflation – this is a big part of the reason why we find ourselves where we are today! Conversely, keeping policy tighter for longer (and potentially tightening further) risks further damaging growth. In recent decades, price stability has been the mainstay of central bank policy and for now at least, comments from the Fed, ECB and BoE suggest this remains the case.

From an interest rate perspective, we continue to believe that risks to rates remain skewed to the upside and the inverted shape of most yield curves should be seen as an opportunity for borrowers to lock in lower rates than what they are currently paying on unhedged debt. That said, risks are obviously two-way, and we continue to have conversations with credit fund managers who are concerned about their returns given what the yield curve is currently implying.

From an FX perspective, we see risk that the dollar will continue to outperform, particularly if it becomes apparent that the Fed isn’t going to cut aggressively in 2024 and the yield curve flattens further. However, the outlook for sterling is less clear. On the one hand, the central bank facing the stickiest inflation has the most scope for raising rates further (which in isolation should be positive for the pound). However, higher rates may not be enough to aid sterling’s cause if the economy slides into recession and investors run for more traditional safe havens. Once again, risks are two-way, but high inflation and a contracting economy leaves sterling in a precarious position.