T. Rowe Price: Hawkish central banks risk global policy mistake - IFA Magazine

Written by Arif Husain, Chief Investment Officer of fixed income at T. Rowe Price

Are we possibly heading towards a worldwide error in monetary policy? The recent aggressive positions adopted by certain influential central banks in developed economies raise valid concerns about this.

There is a real danger that these central banks might tighten monetary policy excessively in order to control inflation, which could potentially plunge the global economy into a recession and trigger a downturn in the financial markets. On the other hand, China's central bank may be committing a different kind of mistake by not implementing enough measures to support the country's economy.

The European Central Bank lacks a consistent history of accurately predicting inflation rates.

The European Central Bank (ECB) demonstrated a highly aggressive stance at its latest meeting, serving as a clear illustration of a major central bank taking a firm stance. In June, the ECB increased interest rates by 25 basis points, with President Christine Lagarde indicating that another hike should be anticipated in July. What caught the market off guard was the ECB's unexpected decision to revise its inflation forecast for 2025, predicting an increase instead of the anticipated decrease. This unexpected adjustment conveyed a strong signal of their assertive monetary policy.

Due to the updated prediction of increased inflation, it is possible that the ECB may raise interest rates once more during their upcoming gathering in September. However, similar to many other central banks, the ECB has not demonstrated a reliable ability to accurately forecast inflation, thus there remains a chance that inflation may be lower than anticipated, leading to excessively strict monetary measures.

Strong Federal Reserve could raise interest rates excessively

Despite keeping interest rates unchanged during its June policy meeting, the Federal Reserve (Fed) plans to raise rates two more times in 2023. Fed Chair Jerome Powell emphasized the Fed's strong stance against inflation by stating that rate cuts are unlikely for the next few years. This was likely an attempt to discourage the market from anticipating rate reductions in the present year, and it succeeded - futures contracts after the Fed meeting indicated the possibility of rate decreases beginning only in early 2024.

The Federal Reserve has stated that it will consider the combined impacts of tightening policies when deciding on further increases in interest rates. This suggests that there may be more time between each rate hike. However, it is uncertain whether this will be enough to prevent a recession. The persistence of essential inflation in the United States and the Federal Reserve's emphasis on bringing inflation back to its targeted 2% could potentially result in excessive rate increases and a reluctance to lower rates promptly when the economy experiences a downturn.

The Bank of England was slow to respond to rising inflation.

The Bank of England appeared to make a wise decision when it chose to increase interest rates early on, coming out of the recession caused by the pandemic in 2020. However, they then took a relaxed approach, assuring everyone that inflation would decrease throughout 2022. Unfortunately, this caused them to fall behind in their efforts to combat inflation, and consumer prices in the UK jumped to more than 10%. Now, public sector employees in the UK are requesting significant wage hikes, leading to concerns that a cycle of increasing wages and prices may be starting.

As a reaction, the Bank of England caught the market off guard by implementing a substantial 50 basis point increase, bringing the interest rate to 5% during its meeting in June. This move has resulted in predictions that the ultimate rate for this particular period will be 6%. If mortgage rates were to rise to 8%, it would have a detrimental effect on consumer spending in a nation where fixed-rate mortgages are not common. Under the strain of persistently high inflation, the Bank of England may find it effortless to further raise rates to a point that could potentially plunge the economy into a recession.

China's post Covid situation is undeniably deteriorating.

Certainly, mistakes in monetary policy by the central bank can manifest in various ways. Rather than increasing interest rates excessively, China may be failing to implement significant cuts that are necessary to maintain economic growth. In June, the People's Bank of China made a meager 10 basis points reduction in its policy rate for one-year medium-term lending facility loans, which was its first cut since August 2022. Although minor cuts were subsequently made in the one and five-year loan prime rates, it is evident that China's economy is losing momentum after the initial boost from its post-zero-Covid policies. Consequently, it may face challenges in achieving even the relatively modest 5% annual growth target set by the government for 2023.

However, China stands out as an exception in a global landscape where numerous advanced market central banks are working to curb inflation. These central banks may be causing additional economic distress by prolonging their efforts to raise interest rates in the face of stubborn inflation. In contrast, certain central banks in emerging markets have effectively brought down inflation by swiftly and significantly increasing rates. As a result, countries like Brazil are now contemplating reducing rates, raising doubts about whether the local currency bonds in these nations are priced too high to account for the accompanying risks. Furthermore, this raises questions about whether advanced market governments have factored in enough risk premium.