My dear Friends,

Remember, rising inflation was the most talked about topic in 2021. Years of a cheap money policy by central banks around the globe and the jump start of economies around the globe had caused the situation.

Despite a recommendation from the IMF in October 2021 to tighten monetary policy, the FED and other central banks continued to claim inflation was “transitory”.

By the end of December 2021, Jerome Powell, the FED‘s chairman, admitted he had misjudged the situation only to raise interest rates four times in 2022, including three jumbo hikes in June and July by 0,75% and again in September.

On October 7th 2022, the very same IMF warns that further interest rate hikes by the FED could cause a global recession.

That is a bit confusing, no? Let’s explore this!

Prices and Policy

By Q4 2021, consumer prices had risen more than economists expected. While a jump in prices was expected as global economies recovered from the pandemic shock.

Persistently high inflation was, however, not part of the playbook and put pressure to act on central banks.

The last thing central banks want is for price gains to become a permanent fixture. This usually ends in a wage-price spiral that further fuels inflation- a vicious circle that easily gets out of control.

In a case like this, central banks need to prepare to remove stimulus measures and raise interest rates to take the steam out of economies. The risk of doing this is kick-starting a recession resulting in a severe hit to labour markets – and voila, the recipe for an economic down spiral.

There are beneficiaries of high inflation-borrowers. They get a big discount on their debt, so they say. Countries with high debt structures benefit as much as investors who use borrowed money for their investments. Due to inflation, the value of money goes down, and so does any debt. Well, in theory, at least.

The downside, however, is that prices for everything else are going up simultaneously, from wages to commodities. Rising costs mean less consumer spending and less profit. The devaluation of a currency also means less foreign investment. All strong criteria for bringing economies down.

Inflation has a sticky psychological side that makes it hard to define winners and losers clearly.

The Dilemma

The big question for markets today is whether central banks can successfully bring inflation down to target while keeping the rate of economic growth above zero.

The path to achieving this is narrow. If central bank policymakers underestimate the strength of their economies, this could result in an extended period of above-target inflation. If they overestimate it, we face a recession. To be honest, nobody knows which path they are on right now.

There is additional uncertainty from tight commodity markets as the war in Ukraine continues. Countries around the world are grappling with securing supplies of grains, gas and fuel, amongst other commodities. China’s lockdown policies are also driving concerns around global supply chains and demand.

Global Scenario

In May 2022, Mme Lagarde, president of the ECB, said the Eurozone‘s monetary policy had reached a turning point only to raise interest rates in Q3 2022 to 1,25%-in two steps. This happened despite the forecast of a severe recession for the Eurozone due to the war in Ukraine.

In September, the Bank of Japan decided to keep its interest rates unchanged(0,10%), despite an inflation rate being above the Bank of Japan’s expectation of 2%. Their decision is based on subdued wage growth and little prospect of strong demand-pull inflation. Further, the assumption of easing energy prices that are set to cause inflation to soften gradually next year.

In Latin America, worst hit by pandemic inflation, inflation stays hot despite several interest hikes. Mexico had ten consecutive interest hikes, and Peru had 13. Brazil, the first country to raise interest rates in 2021, could see a halt in rising interest rates.

“The inflation trajectory remains clouded with uncertainties arising from continuing geopolitical tensions and nervous global financial market sentiments, In this backdrop, MPC was of the view that persistence of high inflation, necessitates further calibrated withdrawal of monetary accommodation to restrain broadening of price pressures, anchor inflation expectations and contain the second round effects”

Shaktikanta Das, Governor, RBI

India’s central bank, RBI, has increased interest rates four times in recent months to keep inflation under control.

At the same time, governments have rolled out plans for more spending pushing in the opposite direction to central-bank policies that are trying to rein in demand. Continuing currency slumps give central bankers around the world particular reasons to stay alert. This is especially true for emerging markets.

The Angst

So, here we are the FED has introduced several interest hikes, but inflation in the US and elsewhere has either not come down or, in some countries, even risen despite interest hikes by other central banks. But why is the US aggressive interest rate policy dangerous to the world economy?

“Things are more likely to get worse before it gets better, the risks of recession are rising”

Kristalina Georgieva, President IMF

A strong dollar is wreaking havoc on emerging markets. A debt crisis could be next. Compared with other currencies, the U.S. dollar is the strongest it has been in two decades. It is rising because the Federal Reserve has increased interest rates sharply to combat inflation and because America’s economic health is better than most.

Georgieva said the IMF estimates that countries making up one-third of the world economy will see at least two consecutive quarters of economic contraction this year. She claims that the world economy could lose the equivalent of $US 4 trillion by 2026 – this is roughly the equivalent of the size of Germany’s economy.

“tightening monetary policy too much and too fast — and doing so in a synchronized manner across countries — could push many economies into prolonged recession.” 

Kristalina Georgieva, President IMF

Ok, the US Fed was the most aggressive what have rising interest rates in the US to do with the world economy?

“macroeconomic tightening in advanced countries can have international spillovers.”

Janet Yellen, US Secretary of the Treasury

A Reverse Currency War

Most governments worldwide prefer relatively weak currencies to help boost exports and make up for demand weakness at home. Not all countries can have a weak currency at the same time, so any action by one country that pushes up another country’s currency could prompt a policy response.

Today, the dynamics are different. Most of the world economy is struggling with inflation, and central banks, led by the Federal Reserve, are raising rates in an effort to slow the increase in prices. Many countries are therefore facing pressure to match the Fed’s tightening policy to prevent their own currencies from weakening excessively—a reverse currency war.

So, tighter policy in the United States pulls in funds from around the world and thereby strengthens the dollar. This weakens currencies in other countries, which generally supports those countries’ exports and should thus help their economies. But a weaker currency also drives up domestic prices, particularly for traded goods. At a time of generalized inflationary pressures and relatively high global prices for imported energy and food, governments are becoming increasingly concerned about their currency’s weakness, especially against the dollar.

However, while the ongoing “reverse currency war” might sound like good news for the US, the nature of the modern global economy means that slowdowns abroad can hurt at home.

Scrambling to keep up

Global monetary coordination is always complicated simply because the world’s leading central banks have mandates directing them to focus on domestic economic conditions.

In theory, floating exchange rates allow different countries to pursue different monetary policies, with the exchange rate acting as the pressure-relief valve. But that would require a willingness to accept large currency fluctuations.

The dollar has now reached a level against many currencies, undeniably a problem for much of the world. The US Federal Reserve’s relentless and aggressive rate rises over recent months to curb inflation have battered most emerging and developed market currencies.

With jumbo-sized rate hikes likely, major economies like the UK, Europe, Japan, and China are vulnerable to a prolonged economic downturn. Since their currencies are already weakening against the dollar, those countries either need to hasten their rate hikes and risk recession or allow the dollar to strengthen further and diminish their own currencies’ values. 

As a result, more than 80 central banks around the world are following the Fed’s lead. They are continuing the tightening plans that kicked off earlier this year and moving aggressively to cool their own unique kinds of inflation.

The World‘s banker

The dollar is the world’s reserve currency– a strong US dollar is the response to troubled times. This attracts investors from all over the world. Sometimes they simply buy dollars, but even if investors buy other assets, like government bonds, they need dollars to do so — in each case pushing up the currency’s value.

That strength has now become much of the world’s weakness. The dollar is the de-facto currency for global trade, and its steep rise is squeezing dozens of lower-income nations, chiefly those that rely heavily on imports of food and oil and borrow in dollars to fund them.

“The entire South Asian continent, which is heavily dependent on imported energy, has been facing a double, or triple whammy, where interest rates are concerned,”

Adam Tooze, Economic Historian, Columbia University, Head of European Institute

Most developing countries owe their debt in US dollars, so many owe much more now than a year ago. As a result, many will struggle to find an ever-increasing amount of local currency to service their debts.

They will either have to tax their economies more, issue inflationary local money or simply borrow more. The results could be a deep recession, hyperinflation, a sovereign debt crisis or all three together, depending on the path chosen. Developing countries which fall into sovereign debt crises can take years or even decades to recover, causing severe hardship to their people.

Four emerging-market countries have defaulted on their debts so far this year, according to S&P Global Ratings: Russia, Sri Lanka, Belarus and Ukraine. Another ten countries are under “severe stress”: Argentina, Lebanon, Ghana, Suriname, Zambia, Ethiopia, Burkina Faso, Congo-Brazzaville, Mozambique and El Salvador, according to the rating agency.

Fact Check

Fact#1:

A significant energy shock, particularly for importers of natural gas, has been layered onto the economic legacy of the pandemic shock. The US has been less hard hit by the energy shock, and therefore inflation in the US is different from the rest of the world, especially inflation rates in Europe.

Fact#2:

All the main parts of the global economy are currently slowing down. The world is effectively already in an undeclared recession.

Fact#3:

High inflation tends to curb demand as households cut back to preserve their finances. Weaker spending tends to lead to lower revenues, which in turn sparks layoffs and kicks off a vicious cycle of economic decline.

Fact#4:

There’s little coordination between policymakers. Instead of officials working in harmony to tame global inflation, central banks are rushing to prop up their own currencies as fast as possible. This can lead to recession, which means a lower output. The US would have to pay higher import prices due to a shortage of certain goods. If prices go up, inflation goes up.

Fact#5:

The FED’s aggressive rate hikes are fuelling a global sense of economic confusion as other central bankers look to defend their currencies against the surging dollar.

FACT#6

The United States is in a proxy war with Russia over Ukraine, and the financial and economic components of the war are just as important as the military component. Just as the U.S. banking system has been weaponized in this war, so has the Fed. Raising interest rates aggressively would reduce the US government’s debts, create a deep global recession that would reduce energy demand, and bring down energy prices.

Editors Pick

It is difficult to predict the future direction, there are too many moving parts in the world economy. One thing, however, is certain the global economy is on the brink of a new macroeconomic era, whatever the US interest rates.

Central banks worldwide are currently committed to bringing inflation down, even if that means sacrificing output. The risk is that the measures adopted to contain inflation work too well, and there will be a strong global downturn.

Well, currently, there are bitter pills to swallow. However, with every change, there is a chance. So, more than ever before, we need to stay informed, level-headed and ready to change a strategy. In short, we need to activate our growth-mindset