Sep 21, 2022

Will higher interest rates push the economy into recession?

With so much global economic uncertainty, investors are more sensitive than ever to the comments of central bankers. They parse every word, trying to figure out how high interest rates will go and whether the hikes will push the world’s major economies into recession.

A couple of weeks back, we saw just how sensitive the markets can be to the words of Jerome Powell, Chairman of the U.S. Federal Reserve, the most powerful central bank in the world.

At the Annual Economic Symposium in Jackson Hole, Wyoming, Powell said the Fed’s “overarching focus right now is to bring inflation back down to our goal of 2%.” He went on to say that “restoring price stability would take some time and requires using our tools forcefully to bring demand and supply into better balance.”

The market interpreted the statement that there will be no quick respite from large interest rate increases, raising the odds of a severe recession. The S&P 500 dropped by over 4%.

Central bankers must be careful about every word they utter publicly because they can have that kind of outsized effect on the markets. That’s why I like to listen to what former central bankers have to say because they can speak more freely about the current situation and what’s led to it.

I recently came across an interview with the former Bank of England Governor, Mervyn King, that I found highly insightful and recommend to everyone interested in where interest rates might be headed in the coming months.

King, who was Governor from 2003 to 2013, calls inflation a sign of a sick economy because wages are constantly chasing after rising prices, creating instability and hardship for households and businesses. That’s why it’s so important to bring inflation under control as quickly as possible.

King believes the current bout of the inflation is the result of two errors committed by the major central banks and the economists who advise them.

When the pandemic hit, central banks printed money to stimulate spending and boost demand. At the same time, you had governments injecting massive stimulus into the economy through direct support programs for households and businesses.

However, the pandemic caused a shutdown of economies, constraining production and the supply of goods and services. “You [had] a classic case of too much money chasing too few goods and the result of that is inflation,” says King, speaking in May. He believes government stimulus should have been sufficient to support the economy without the need for central banks to print money.

The second mistake was to rely on economic models that failed to take into account what was actually happening in the economy and instead relied on inflation targets. King noted central bankers can’t make inflation return to a 2% simply by setting a target. Words have to be backed by aggressive interest rate hikes to bring demand back into balance with supply.

As we saw during the inflationary spiral of the 1970s and 1980s, the sooner tough action is taken the better to avoid the need for even more draconian action in the future, he says.

As if they’d listened to King’s advice, that’s exactly the approach that’s been taken in recent months by the Federal Reserve under the leadership of Powell and the Bank of Canada under Governor Tiff Macklem as well as by other central banks. They’ve hiked rates aggressively and clearly signalled more increases are to come until inflation is brought under control.

How high will interest rates go? King says there is no way to know in advance. But he does note the near-zero rates in recent years were historically unusual and unhealthy for the economy because they distorted investment decisions. Will the rate hikes cause a recession? Here again, he won’t make a prediction, except to say it’s likely but not inevitable.

In fact, this former central banker doesn’t have a high opinion of forecasts in general. Who predicted, for example, the pandemic in 2020 or the Russian invasion of Ukraine this year?

“The mistake is to believe you can make accurate forecasts,” he says. “The more important thing to do is not to pretend that we know inflation is going to be 3.2% in a particular year but try to identify the risks. What are the risks on the upside and the downside? What actions can we take to mitigate those risks?”

This is exactly the approach we take in managing investments. We don’t try to predict the future but instead construct portfolios that reap returns from markets while prudently managing risk.

No one knows how high interest rates will go or whether a recession is in the offing. But we can prepare ourselves for different scenarios and then meet challenges as they come with patience and optimism.

For more insights into investing and personal finance, please download our Capital Topics podcast.

James Parkyn
James Parkyn

James is a founding partner and Portfolio Manager at PWL Capital Inc. in Montreal with over 25 years of experience helping clients achieve their financial goals.

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