Please see below article received from Brewin Dolphin yesterday evening, which discusses why inflation remains high, whether a US recession is imminent, and the longer-term outlook.
Why is inflation still high after multiple rate hikes?
Interest rate changes can take a long time to materially affect inflation. Part of the reason is that many loans have fixed terms, where the interest payment does not immediately reflect changes in the central bank policy rate. Rate hikes have started to make an impact, but it will take time for the full effect to be felt.
The extent to which rate hikes influence different inflation categories varies. Central banks exercise a lot of control over house price and rental inflation, as this is a very interest rate-sensitive sector. Rate hikes have already depressed real-world rental inflation, but this takes time to impact consumers as it depends upon when rental agreements are renewed.
Wage inflation tends to be the most important determinant of services inflation excluding housing. The eventual drop in consumer and business spending from rate hikes leads to weaker demand for workers, which then depresses wages. In this sense, rate hikes have a big impact on services ex-housing inflation, but there can be long lags. At present, labour markets in many countries are very tight. For example, in the US there are currently 1.6 job openings for every unemployed worker. This tightness is keeping services ex-housing inflation running strong, notwithstanding the building headwind from higher rates.
Rate rises tend to have a weaker impact on tradeable goods inflation. Food inflation has dropped sharply in recent months in the US, but it remains strong in the UK and other European countries. The Russian invasion of Ukraine, regional weather and its impact on harvests, and foreign exchange movements explain much of the relative divergence in food price inflation in the US and Europe.
When will mortgage holders feel the impact?
It goes without saying that those who are on variable[1]rate mortgages are already feeling the impact of higher mortgage rates. But most households in the US and UK are on fixed-rate deals. Some households on fixed-rate mortgages have already begun to marginally reduce their spending in anticipation of their deals coming up for renewal at higher rates. In its May monetary policy report, the Bank of England (BoE) estimated that higher mortgage rates reduced UK aggregate household consumption by 0.3% in the first quarter of the year. This reduction in spending is being driven by mortgage holders on variable rates as well as those on fixed rates that have already reset.
We would expect that the majority of the reduction in spending will occur when fixed-rate deals actually renew. Roughly 85% of residential mortgages in the UK are fixed, but with terms for the most part at five years or less. The BoE estimates that higher mortgage rates will reduce aggregate household consumption by almost 0.5% by the fourth quarter of 2024. Notably, mortgage terms in the US are generally fixed for a much longer period, often to 30 years.
Another potential impact of higher mortgage rates is an increase in homeowners defaulting on their loans. The extent to which defaults occur will be linked not just to how high mortgage rates go (and for how long they stay there), but also by how the economy evolves. It is safe to say that if unemployment rises substantially, mortgage defaults will increase.
Have rate hikes been more effective in the US?
Several forces have brought inflation down faster in the US than in other regions. For one, the Federal Reserve (Fed) has been more aggressive in its monetary tightening efforts compared to most other central banks. The Fed has so far raised rates by five percentage points. This is above the 4.4 percentage points of hikes implemented by the BoE and 3.75 percentage points of hikes by the European Central Bank.
Meanwhile, until last autumn, the US dollar was strong, which depressed traded goods inflation. Weak European currencies relative to the dollar had the opposite effect. In addition, the inflation stemming from Russia’s war in Ukraine has had more of an impact on Europe. Wage-driven inflation has been a factor on both sides of the Atlantic, as demand for workers has been strong. But the UK has struggled more than most countries with labour supply, with Brexit likely a contributing factor.
What is the relationship between rate hikes and recessions?
Of the 13 Federal Reserve rate hike cycles since the mid-1950s, ten have been followed by a recession that began within a year-and-a-half of the last rate hike of the cycle. While this is clearly a high hit rate, it’s important to note that tightening cycles don’t happen in isolation and are not always the main driver of a recession.
Of the four US recessions that have occurred since 1990, the Fed certainly played a role, but the rate hikes were arguably not the primary cause of any of them. In two of these cycles, a shock rather than rate hikes was the primary cause of the recession. This was the case in 1990, when the economy only went into recession after the oil price spike due to the Gulf War. It was also the case in early 2020, when the recession was all about the Covid shock and had little to do with the Fed’s rate hikes of 2018.
In the other two cycles, the recessions were driven more by the unwinding of large excesses. In 2001, the recession was much more about the contraction in technology-related investment spending than it was about Fed rate hikes. Consumer spending (which represents about 70% of the economy) didn’t decline at all in that recession. In 2008/09, Fed rate hikes certainly acted as a catalyst (as was the case in 2001), but the recession was more about the unwinding of the excesses in banking and housing following a period of very lax lending standards. The main point is that the relationship between rate rises and recessions is not straightforward.
We believe it is more likely than not that the US suffers a recession, with a start date at the end of this year or perhaps in early 2024. But our conviction in this forecast is not high as there are pathways to a ‘soft landing’ (a slowdown in economic growth that avoids a recession). Europe and the UK may avoid an outright recession, but we expect growth to be sluggish. If a US recession does occur, it will likely be mild. A mild recession would limit increases in both the unemployment rate and mortgage defaults. It is also worth highlighting the supply/demand backdrop for housing, which is tight. House prices will suffer as this BoE rate cycle goes on, and to the extent that unemployment rises. But because there is so little supply, that should help to limit the declines. Similar supply and demand dynamics exist to support UK house prices in the face of higher mortgages rates.
What has happened historically after periods of low interest rates?
Central banks hiked rates rapidly in several periods during the 1970s and 1980s, but rates were not low heading into these cycles. Rates were low for a long time following the global financial crisis of 2008, but the subsequent rate hike cycles (2015-18 for the Fed and 2017-18 for the BoE) were very modest. There’s no good historical precedent for the current environment.
Mark Twain’s quote, “History does not repeat itself, but it often rhymes”, is often used to compare economic cycles. As highlighted above, some cycles involve shocks. Other cycles involve the build-up and subsequent unwind of excesses and imbalances. Some cycles see both occur. This cycle has its own similarities and differences with those of the past.
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Chloe
19/05/2023
