The response to interest rates and inflation

Advanced-country central banks, as expected, are generally tightening monetary policy in response to inflation that has gone higher and stayed higher for longer than they forecast.

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We have been forecasting interest rate rises from most countries, and downward revisions to growth forecasts. Only Japan has been exempt from these pressures, with inflation that remains low. The European Central Bank (ECB) has chosen to persist with bond buying and ultra-low rates despite the substantial inflation in the zone, though all the talk there is now of tightening to come. Markets expect the cessation of money printing and possible rate rises before the year end. European bonds have fallen in anticipation despite rates staying on hold from the central bank. This remains a poor background for most bonds, where prices of the bonds fall when markets demand a higher rate of interest or return on the bonds available where the interest payments are fixed.

The general trend of rates in the rest of the world is also upwards as the US Fed seeks to catch up with inflation through a series of rate rises. Countries worried about their foreign exchange position and their ability to pay their overseas debts have been forced into large rate rises partly in response to planned moves in dollar rates.

Russia had high rates before the damaging invasion of Ukraine. They now stand at 17% with extensive capital controls. Sri Lanka pushed its rates up by 700 basis points to 14.5% to try to stem the flow against the currency. Egypt put in a 100-basis-point rise to 9.25% as markets questioned its vulnerability to rising food costs. Turkey is on 14% with political interference stopping higher rates to arrest the inflation. Chile had a sharp rise of 150 basis points to 7% and Brazil 100 basis points to 11.75%.

Dollar strength an EM problem

Emerging-market economies are aware they need to avoid too sharp a devaluation against the dollar fuelling higher inflation of imports and in some cases undermining confidence in the solvency of the state. China in contrast has recently shaded her rates and is having to think about further relaxation. Inflation remains low and the state attack on property speculation and lending coupled with renewed covid lockdowns have had a depressive effect on activity and on some prices.

Many countries are into rate rises, with Korea and the UK having had recent 25-basis-point rises whilst Canada and New Zealand went for a 50-basis-point increase. Mexico and the Czech Republic have also recently hiked by 50 basis points. Poland went for a full 1% to take its rate to 4.5% as did Hungary to go to 4.4%. These moves will slow the economies and make people and companies more cautious about taking on extra debt. In each case, the main motive is to tackle inflation by dampening demand a bit.

Both the IMF and the World Bank have cut their forecasts for 2022, as has the ECB.

As a result of central bank action and the depressing effects of the Ukraine war various official forecasts for growth are being lowered by governments and international bodies. Both the IMF and the World Bank have cut their forecasts for 2022, as has the ECB. There is a general recognition that the best of the recovery from lockdowns outside some Asian countries has now happened. The large increase in energy and some other commodity prices acts as a kind of additional tax on individual incomes, reducing the scope for other types of spending.

The IMF took 0.8% off its world GDP forecast for 2022 in its latest publication, taking it down to 3.6%. The ECB forecast 3.7% growth this year for the Eurozone but thought it could be as low as 2.3% if trade remained disrupted and inflation was higher. The IMF expects 2.8% for the Eurozone.

IMF GDP forecasts






Some profit from inflation

In equity markets there are direct beneficiaries of the bad inflation news, as energy and commodity producers see higher turnover and profits. Meanwhile, other companies need to respond to the increase in energy and materials costs. Netflix revealed a small drop in its number of subscribers which led to a sharp downrating of the shares.

A company cannot expect to command a premium rating as a great growth prospect if it cannot sustain sales growth. Markets looked at the growing competition from Apple, Amazon, Disney and others and reappraised the outlook. Some consumers will be thinking their download entertainment might be an area for cuts when their incomes are stretched by food and fuel bills. Other consumers might want to switch provider depending on the films available and the new material coming on stream.

These experiences remind investors of the need to be more discriminating over companies and sectors. Rewards come to those who stay with or invest in those companies and areas where growth can be sustained and where margins can be maintained despite the more difficult general background of squeezed real incomes and rising costs.

The official forecasters in the central banks and international institutions still believe the inflation will peak this year and will fall off rapidly once energy and food costs start to decline from their peaks. They also believe the main economies will get through without tripping economies into recession. This provides a reasonable background for investors.

We will be watching carefully to see if policies followed make this outcome likely. We need the Goldilocks touch from the governments and central banks. They need to toughen policy enough to ensure inflation falls, but not too much that economies stall. So far, so good.

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The response to interest rates and inflation

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