Asset Management Europe: Monthly Macro Insights – April 2023

The global economy started the year on a firmer note than feared. Yet, core inflation is still stubbornly high while banking sector woes make it clear that the most aggressive tightening cycle in decades is taking its toll. Correspondingly, central banks will have to balance the risks between price and financial stability.

Stronger activity in early 2023

Survey indicators have strengthened from the troughs seen in late 2022. Consumer confidence has started to improve while business survey indicators have rebounded from the November low, especially in the services sector. Regionally, China’s reopening bounce is gathering some steam – although at a more moderate pace than expected – alongside a European rebound from its energy price shock.

Will the high-for-longer be challenged by rising financial stability concerns?

Most central bankers have insisted that policy rates will have to stay elevated for some time in order to restore price stability, and while financial stability risks have risen, they are unlikely to relinquish their inflation target. Indeed, banks are globally much better capitalised than they were in 2008 and the quality of their loan books, especially the case for mortgages, is stronger.

While recognising the risk of an adverse credit shock, markets are signalling that the recent stress on US and European banks is contained and limited by policymakers’ actions. In fact, it almost seems like the most pronounced and swift global monetary tightening in at least four decades will only have a marginal impact on economic activity, prompting some investors to go as far as to foresee a “no landing” scenario, with global growth barely softening in 2023.

Are monetary policies ineffective?

The basic idea with tighter monetary policies is that higher interest rates will slow overall demand in the economy, which will in turn reduce inflationary pressures. However, the transmission is generally thought to have long and variable lags, changing over time in response to cyclical and structural changes in the economy.

One school of thought suggests that the lags may have shorten in part because of policy guidance and central banks’ credibility that, in effect, allows financial markets to react to policy before it is implemented. Correspondingly, financial conditions in the marketplace began changing in anticipation.

Conversely, there are two factors that, by themselves, are likely to have lengthened the time it takes for monetary policy to affect the economy. First, the high share of fixed-rate credit in the economy is contributing to impede monetary policy via its effect on the cash flows of borrowers. Yet, as those fixed-rate loans reset at a higher interest rate, borrowers will be faced with a sizeable jump in their required mortgage payments.

Secondly, labour markets are tight in most countries, as evidenced by the sharp rise in vacancies and vacancies-to-unemployment ratios. In this environment, businesses are very reluctant to lay off workers as, two years after the onset of the COVID-19 pandemic, the hiring process is challenging and costly. Therefore, the labour market is less flexible with businesses slower to respond to weaker demand, and cooling it off might require a higher-than-expected level of policy rates.

Overall, the lags might have lengthened, but there are few reasons to think that monetary policy has become inoperative. As such, the full – negative – impact of the synchronized tightening is likely to be felt in the coming months, which seems to have only been internalized by the sovereign bond markets.

Completed writing on 3 April 2023.

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