Catch-22: Inflation or Recession?

It was a busy month for central banks, with all three of the majors meeting and two holding press conferences. If the question going into this was “Is inflation or stalling growth a bigger concern?”, we got at least two clear answers, with one bank leaving a little more to the imagination.

First up we had the ECB – although more politically and economically exposed to the conflict in Ukraine – who made it clear that inflation is the concern, and it will be addressed. The council unexpectedly accelerated the timeline to stop bond purchases in the hopes of slowing bond buying in May, with an aim to end the program as early as Q3. The move comes on the back of higher inflation forecasts and is coupled with a change in language around hikes – hikes are now expected “some time after” the end of QE rather than “shortly” after – giving the ECB a little breathing room. This didn’t stop traders pricing in almost 50bps of hikes this year, pushing the curve close to its steepest so far in 2022. The rising of a common enemy to the east has helped solidify European unity in the short term but economic challenges are on the horizon. If inflation persists and quick hikes are required, the relative weakness of southern states will again be front and centre. The developments from the ECB caused an immediate spike in the cost of Italian borrowing versus German and was insufficient to cause any significant Euro strength. If the UK and US are risking recession with quick rate hikes, the ECB may be risking the EU project.

The Fed struck an even more hawkish tone. After hiking 25bps as expected, the vaunted dot plot shows that Fed members expect 7 more hikes for 2022, with rates reaching 2.75% by 2023, above the long run rate of 2.375%, pushing rates into restrictive territory. Powell’s press conference continued the tone as he described the US economy as “very strong” and the risk of recession “not particularly elevated.” Risk of recession may not be elevated but it is catching market attention – as rates actively cool the economy and 2s10s curve heads toward zero (negative being a recession flag) market participants will be watching for any weakness in data to flip the narrative on the Fed.

At home, messaging from the BoE lacked the clarity seen in Europe and America. Though hiking 0.25%, the MPC softened language in the release suggesting that further tightening “might be” appropriate and noting that “there was risk on both sides of that judgement.” Despite raising inflation forecasts, due to the war, we had no one calling for a 50bps move this time around and, in fact, Jon Cunliffe voted for no hike at all.

The market inference is clear – central banks plan to front load hikes to fight inflation, even if the cost is a recession. Recession warning signs have started to appear, with 2s10s spread heading back toward zero and Italian/German spreads blowing out but for now, central banks are not perturbed. The risk to floating rate borrowers is that current market pricing is insufficient to curb the bout of inflation seen in the global economy and even more aggressive hikes are required, but it seems central banks around the world are ready to act if needs must.