Will frontloading make hard landings less likely?
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Will frontloading make hard landings less likely?

The pace of policy tightening has increased still further, with many central bankers arguing that rate hikes must be “frontloaded” to tackle inflation risks quickly. In the current environment, this probably does offer the best chance of avoiding a future hard landing for most economies. And given evidence so far that activity is slowing but not slumping as policy tightens, aggressive rate hikes seem set to continue in the near term. But while this policy may reduce the threat from inflation in the medium term, it carries big economic risks in the near term, particularly where household debt is high and house prices are elevated.
  • Banks are frontloading rate hikes to stem inflation risks and avoid more pain later on.
  • Early signs are ok, with inflation expectations down and demand weakening somewhat.
  • But rates could need to fall back before long, especially where housing risks prevail.

The pace of policy tightening has increased still further, with many central bankers arguing that rate hikes must be “frontloaded” to tackle inflation risks quickly. In the current environment, this probably does offer the best chance of avoiding a future hard landing for most economies. And given evidence so far that activity is slowing but not slumping as policy tightens, aggressive rate hikes seem set to continue in the near term. But while this policy may reduce the threat from inflation in the medium term, it carries big economic risks in the near term, particularly where household debt is high and house prices are elevated.

The case for frontloading

Generally, central banks are now moving faster than financial markets had expected and in some cases even more rapidly than our own more hawkish forecasts had implied. Recent rate hikes have typically ranged from 50bp to 100bp and the more normal increment of 25bp seems to be out of fashion. Details of recent moves and our forecasts can be found in Table 1. Various central bankers have argued the case for “frontloading” interest hikes when justifying those changes or when calling for equally aggressive action in the near future.

Their argument is that bold action now will reduce the risk that even more aggressive or painfully drawn out tightening will be required in future. That stems from the view that it is important to get a grip on inflation quickly rather than allowing high inflation to persist and thereby running the risk that inflation expectations and underlying price pressures are allowed to spiral higher. In that scenario, bigger or more prolonged hikes might be required in future to bring inflation under control. There is also an argument that interest rates need to rise particularly quickly at the start of the cycle to get them back to “neutral” levels and out of stimulative territory.

We have some sympathy for this argument and have highlighted that monetary policy tightening has been particularly damaging in past episodes when inflation had already been allowed to get out of control (see here). The Bank for International Settlements (BIS) presented further evidence in support of this view in a BIS Bulletin last month. It identified 70 tightening episodes in 25 countries over the period 1980–2019, 41 of which ended in hard landings (a recession in the three years after the peak in interest rates) and 29 in soft landings. As one would expect, it found that hard landings more often occurred when the total increase in interest rates was larger. More interestingly, though, soft landings were more common in instances of frontloading i.e. when the percentage of the overall hike that happened within the first two quarters of the tightening cycle was higher. (See Chart 1.)

Chart 1: Size, Duration and Timing of Rate Hikes under Hard and Soft Landings

Source: Bank for International Settlements

A shorter cycle duration was also more commonly associated with soft landings, suggesting that “there is little to be gained in terms of output from a shallower and more drawn-out tightening path”.

Reasons for concern

However, as the BIS also notes, there are several caveats. Our own analysis of past recessions has highlighted that monetary tightening has been particularly damaging when undertaken in conjunction with high debt levels and/or overvaluation in housing markets. Household debt has fallen since the financial crisis, particularly in the US. But it is still relatively high in many economies and the increase in the debt interest burden is set to match that seen in the run-up to the global financial crisis on average in major advanced economies.

What’s more, house prices look overvalued in Canada, Australia and New Zealand, implying a much bigger threat of a correction as policy is tightened. There are risks in that regard in the UK and US too. These risks are higher in an environment of rapidly rising interest rates given that households might struggle to plan and to adjust. In short, there is a very difficult balance for central banks to reach between tightening policy quickly enough to contain inflation expectations, but not so quickly that firms, households and financial markets cannot cope.

Some encouraging signs so far

The early signs offer some hope that they are striking this balance fairly well. First, financial markets’ long run inflation expectations have edged back down as central banks have become more hawkish. (See Chart 2.) So it is possible to argue that the frontloading of interest rate hikes has served to temper risks of an inflation spiral.

Chart 2: 5-Year/5-Year Forward Inflation Compensation Implied by Bond Markets (%-pts)

Source: Refinitiv, Capital Economics

Second, financial conditions have tightened as interest rates have risen, but not excessively so. Some tightening is a necessary precursor to the reduction in demand that will be needed to bring inflation into check. But the tightening has not yet become disorderly and there are few signs of severe stress in financial markets. Our own Global Financial Conditions Index suggests that conditions are now approximately as tight as they were in 2011/2012, but nowhere near as tight as in 2008. (See Chart 3.)

Chart 3: Capital Economics Global Financial Conditions Index (Z-Score)

Source: Refinitiv, Capital Economics

Third, interest rate-sensitive spending has generally weakened but not fallen off a cliff. We are in the process of creating some composite indicators of the parts of economic activity that are typically most sensitive to interest rate hikes, with a view to monitoring the early effects of policy tightening and warning of any signs that a severe downturn is underway. We have certainly seen some slowdown among the key indicators, including car sales and mortgage approvals in the US and UK. But so far, this weakness is probably no more than central banks would have anticipated and not enough to dissuade them from frontloading. (See Chart 4.)

Chart 4: Interest Rate-Sensitive Activity Indicators
(Dec 2019 = 100)

Source: Refinitiv, Capital Economics

What’s more, the reduction in demand seems to have caused supply shortages to ease, which should help to reduce price pressures. Note, for example, that the latest PMI surveys revealed that fewer firms are reporting an increase in suppliers’ delivery times.

All of this supports our assumption that central banks will press on with aggressive interest rate hikes in the near term. They will cause their economies to weaken, but recessions are generally likely to be shallow, with easing inflation pressures allowing central banks to cut rates back to more normal levels in 2023/2024. (See our Global Economic Outlook.)

A very narrow path to tread

But there are clearly major risks around this frontloading strategy and central banks are walking a very narrow path between too little tightening and too much. The biggest two threats stem from housing markets and commodity prices. We have already seen weakness in housing markets in Canada, Australia and New Zealand and we suspect that this will push all three economies close to recession and force their central banks to cut interest rates next year. The threat from housing is also significant in the US and UK. As for commodity prices, there is a very real risk that gas prices in particular continue to rise, which would raise the chances of a persistent increase in inflation in the euro-zone especially. In that event, the ECB might be forced to hike interest rates much further into restrictive territory than even our above-consensus forecasts assume, consistent with a much harder landing for the economy.

Monetary Policy Developments

Review of recent policy changes

The hiking cycle is now in full swing, with a total of 20 rate hikes in June and July combined and only two cuts, both of which were in Russia. (See Chart 4.)

Chart 4: Changes in Policy Interest Rates (number of hikes/cuts)

Source: Bloomberg, Capital Economics

What’s more, many central banks have surprised markets with bigger-than-anticipated hikes in the past month. The ECB opted to begin its tightening cycle with a 50bp hike, the Swiss National Bank did the same, the Norges Bank upped the pace to 50bps and the Bank of Canada went for 100bps. Meanwhile, the US Federal Reserve hiked by 75bps as expected and the Bank of England and the Reserve Banks of Australia (RBA) and New Zealand (RBNZ) each delivered 50bp hikes.

DM tightening cycle has further to run

With central banks still striking a hawkish tone and inflation still very high, there are more large rate hikes to come. We expect the ECB to hike by 50bp again in September and October. But in several other cases, we think that the pace of tightening is set to slow amid concerns of adverse economic implications and hopes that inflation pressures are beginning to subside. For example, we see the Fed and the Bank of Canada hiking by 50bps and 75bps respectively in September, while the SNB is likely to opt for a smaller 25bp hike. The pace will continue to slow towards the end of the year before rate cuts come into prospect. We expect the Fed, the Bank of Canada, the RBA and the RBNZ to cut interest rates next year and most others should follow in 2024. So while our near-term interest rate forecasts are typically higher than the rates implied by overnight interest swaps, we think that rates will have fallen closer to markets’ expectations by the end of 2024. (See Chart 5.)

Chart 5: CE Interest Rate Forecasts Vs Market

Source: Bloomberg, Capital Economics

The net asset purchases of the major advanced economies have shifted to net disposals as the Fed’s quantitative tightening has got underway. This run-off will continue, with the Bank of Japan, RBA and before long Sweden’s Riksbank also allowing their asset holdings to decline. But the effect will be partly offset at the global level by renewed ECB purchases as the Bank uses its Transmission Protection Instrument to keep peripheral spreads under control.

Tightening cycles nearing an end in some EMs

The EM tightening cycle has continued apace, with parts of Asia recently joining the party. Mounting fears about inflation have led Korea’s central bank to up the pace of tightening while the central banks of the Philippines and Malaysia are now also hiking. Elsewhere, sharp currency declines have prompted further aggressive hikes in Hungary and Chile.

We expect tightening cycles to draw to a close in Latin America and Emerging Europe over the coming months, although interest rates are likely to remain above their neutral levels this year. Policymakers in Emerging Asia will continue to raise interest rates less aggressively than elsewhere in the emerging world, while the People’s Bank of China is likely to keep policy rates on hold to support the economy.

Table 1: Central Bank Hub

Country

Next Meeting

Policy Rate

Next Change

End-2022

End-2023

End-2024

Balance Sheet

Major Advanced Economies

     

US

21 Sep.

2.25-2.50

+50bp (Sep. 2022)

3.50-3.75

3.25-3.50

2.75-3.00

Balance sheet run-off has begun - pace to reach $120bn next year.

Euro-zone

8 Sep.

0.00

+50bp (Sep. 2022)

1.25

 2.00

1.50

Will have to use new Transmission Protection Instrument to keep peripheral spreads under control.

Japan

22 Sep.

-0.10

None on horizon

-0.10

-0.10

-0.10

Balance sheet will shrink slightly as emergency loans are repaid and continued gross bond purchases are broadly offset by bond redemptions.

UK

15 Sep.

1.75

+25bp (Sep. 2022)

2.50

3.00

2.50

Gilt sales of £10bn per quarter to start from September.

Canada

7 Sep.

2.50

+75bp (Sep. 2022)

3.50

3.00

2.50

Stopped reinvesting maturing bonds in April. With 40% of the Bank's holdings set to mature within two years, active bond sales are unlikely.

Australia

6 Sep.

1.85

+50bp (Sep. 2022)

3.35

3.35

3.10

Bank will allow bond holdings to run off, but no outright sales.

Switzerland

22 Sep.

-0.25

+25bp (Sep. 2022)

0.75

1.00

0.50

Very little anticipated, unless franc appreciates.

Sweden

19 Sep.

0.75

+25bp (Sep. 2022)

2.00

2.00

1.50

Asset sales to begin by end-2022.

Denmark

-0.10

+35bp (Sep. 2022)

1.00

1.75

1.35

Norway

18 Aug.

1.25

+50bp (Aug. 2022)

2.50

2.50

2.25

New Zealand

17 Aug.

2.50

+50bp (Aug. 2022)

3.50

3.00

2.75

RBNZ to sell $5bn of its bond holdings every fiscal year.

Major Emerging Economies

     

China

2.10

None on horizon

2.10

2.10

2.10

-

India

5 Aug.

4.90

+50bp (Aug. 2022)

6.15

6.40

6.40

Brazil

21 Sep.

13.75

+25bp (Sep. 2022)

14.00

11.00

7.50

Russia

28 Oct.

8.00

-50bp (Jul. 2022)

7.00

5.50

5.50

Mexico

11 Aug.

7.75

+50bp (Aug. 2022)

10.00

9.50

8.50

South Korea

25 Aug.

2.25

+25bp (Aug. 2022)

3.00

2.50

2.25

Turkey

18 Aug.

14.00

+500bp (H2 2023)

14.00

25.00

25.00

Indonesia

23 Aug.

3.50

+25bp (Q4 2022)

3.75

4.50

4.50

Poland

23 Aug.

6.50

+50bp (Aug. 2022)

7.50

7.00

5.50

South Africa

22 Sep.

5.50

+75bp (Sep. 2022)

6.75

7.75

6.75


Jennifer McKeown, Head of Global Economics Service, +44(0) 207 811 3910, jennifer.mckeown@capitaleconomics.com

Jennifer McKeown Head of Global Economics Service
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