Inflation rises again while Musk and Dimon warn on outlook
Central Banks grapple with rising inflation and slowing
growth
Warnings from JP Morgan’s CEO Jamie Dimon that an “economic hurricane” is on the way and from Elon Musk that he has a “super bad” feeling about the economy shine a light on the dilemma faced by central banks attempting to raise interest rates high enough to tame rampant inflation without exacerbating the slowdown in growth or even triggering a recession.
It’s well documented that energy costs have been the primary cause of inflation to date and, to an extent, central banks have been prepared to look through this, citing the reopening of the post-COVID global economy and Ukraine as temporary supply-side factors driving up energy costs. However, central banks will be concerned if inflation becomes more broad-based and entrenched. Should this happen, a more restrictive monetary policy regime than that currently factored into forward rates will almost certainly be the outcome.
Inflation is at risk of becoming entrenched
Eurostat’s flash estimate for inflation in May illustrates this point. Figures just released show that headline inflation rose by 8.1% y/y in May, up from 7.4% in April and that energy costs accounted for 39.2% of the rise in costs. However, when volatile components (energy, food, alcohol and tobacco) are stripped out, core inflation still rose by 3.8% up from 3.5% in April, almost double the ECB’s 2% target. Similarly, in the UK, while energy and transport costs are the main factors driving inflation to 9%, other components like food and services are also rising sharply.
Are forward interest rates realistic?
In response to rising inflation, central banks tightened by 0.25% in the UK and 0.50% in the US in May. Market implied expectations for terminal interest rates—the highest point in a rate-hiking cycle—have also ratcheted higher over 2022. Back in January, terminal rates were expected to be no higher than 1.8% and 1.25% in the US and UK respectively. Estimates for these terminal rates have since risen to 3.15% and 2.65%. Although the ECB’s official target rate remains unchanged at -0.5%, the terminal rate for Euribor is already at 1.84%, the market having anticipated last week’s belated announcement from President Lagarde that the ECB’s negative rates policy would end by September with “further normalisation towards the neutral rate”.
This concept of a neutral rate of interest has become a hot topic in recent months. The idea being that interest rates would need to move from expansionary settings, close to or below zero, introduced to weather COVID to at least a neutral level to tame inflation. Although unobservable and nebulous, the upper bound for the UK’s neutral rate is thought to be 2.5%. For the ECB, the upper bound is considered to be close to 2%.
Rates environment is still expansionary for now
At -0.5% in the Eurozone and 1% in the UK, official interest rates are still expansionary. Markets don’t expect the ECB to move this month but do expect the UK to raise interest rates again by 0.25% to 1.25% and for the US to raise rates by a more aggressive 0.5% to 1.5%. This month’s moves, plus additional rate increases over the rest of the year, will bring UK and Eurozone rates back into the neutral range. But will a neutral rate of interest be sufficient to take medium term inflation back down to 2%, at a time when inflation in both the Eurozone and UK is already more than 4 times this 2% target and still rising?
With the war in Ukraine hitting 100 days and no resolution in sight, the pressure on energy and agricultural commodities prices are likely to persist for some time and economic conditions are likely to remain volatile. Unlike the Federal Reserve which has a dual mandate (employment and inflation), the Bank of England and ECB sole mandate is to maintain price stability at, or close to, 2%. Should inflation remain persistent and become more broad-based, a neutral interest rate may not be high enough to enable these central banks to meet their medium-term mandate. In the absence of Dimon’s “economic hurricane” or Musk’s “super bad” economy, it would be a remarkable feat if central banks could engineer a return of 2% inflation without implementing a restrictive monetary policy.
With so much uncertainty, expect markets to remain volatile
We’re seeing a significant increase in appetite from borrowers to hedge their interest rate risk. At a time when there is so much uncertainty around growth, costs and interest rates, hedging instruments in the form of derivatives like Caps, Swaps and Swaptions can be a tactical solution providing borrowers with greater visibility over borrowing costs while providing time for businesses to adjust to a different, and more challenging, operating environment.
For more information on how Vuca Treasury helps borrowers manage interest rate risk, or for advice on how to manage your financial risks, please contact the team by mailing hedging@vucatreasury.com
Martin Mulligan
Partner
Martin Mulligan is the founder of Vuca Treasury. Since 1994, Martin has structured and sold foreign currency, interest rate and commodity hedges for corporate and financial institutional clients at a number of major banks in Ireland, Australia and the UK.