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Central banks' unpalatable choice

An unexpected - in the sense of going against all its own prior guidance to the market - rate hike of 75 basis points from the Federal Reserve this week rammed home the message that the US central bank is serious about doing everything in its power to halt the march of inflation, even if the problem is largely imported. 

Like the UK, the US is suffering its highest rate of price rises in 40 years.

US inflation had been expected to fall slightly this month, delivering a signal that a corner had been turned. But when the numbers were released at the end of last week, the headline rate of inflation had in fact risen, to 8.6 per cent 

That unexpected rise we can guess helped swing the Fed’s decision. 

The current market mood is reviving memories of the 1980s when a previous chair, Paul Volker, didn’t hesitate to tip the US economy into recession as he tried to slay an even bigger and longer running inflation problem. We might not be at that point but we are also a long way from 2010 when Warren Buffett wrote a thank you note to the Federal Reserve for its policy of continuing with quantitative easing. The Fed this week began a well-flagged unwinding of its $9tn balance sheet and the impact of this is likely to be increased market volatility. 

What will our own central bank’s decision this week be? Another 0.25 percentage points or a bolder half per cent? The Bank of England faces the same stark choice as the Fed Reserve between recession and runaway inflation. The longer we wait to crush the life out of inflation, the more entrenched it could become. But turning the interest rate dial up too far, too fast risks choking off what little growth there is, while the impact on borrowings could be severe. Years of low rates have encouraged high levels of personal and corporate debt.  

Members of the committee will be well aware of the accusations they have not acted fast enough or aggressively enough so far, while the more the government steps in to support households - which it has already done with a £15bn energy support package, and could do again with a cut to fuel tax for example – the more likely it is that the members will decide to counter this with a bigger hike.  

Market watcher Neil Wilson thinks the BoE will be forced to go a lot further with hikes, and do it quicker.  “Wages,” he writes, “ will be the last to tame which will require central banks to not simply tighten but engineer a recession.” And he concludes it’s no one’s fault but central banks’ own. “They sat for too long – they didn’t suck the money back out as quick as they had injected… they now need to hike into a meltdown.” 

Every new release of data, and every revised forecast, seems to add to the pile of evidence that the UK economy is slowly sinking into a recession. The IMF, the OECD and now the ONS, with its revelation that the economy missed forecast growth in April, falling 0.3 per cent after a fall of 0.1 per cent the previous month. The toll on economic growth is expected to continue as rising costs and rising interest rates hurt businesses and hold back consumer spending.

While the UK market has been holding up well, at least compared to the US, investors cannot ignore the recession/stagflation risk and the impact that it might have on shares. There is every chance that we will skirt the worst of an economic downturn, and avoid a deep or prolonged bear market, and that the one will not cause the other. But we might not, plus there are plenty of downside risks – for example a serious food security crisis following from Russia’s destruction of Ukraine’s wheat and planting of landmines. Any erosion of confidence could accelerate a wider sell-off, but expecting it means investors are less likely to panic sell. We still need a few more pieces of the puzzle to fall into place. In the meantime our cover feature focuses on making use of value to provide a degree of safety in challenging markets and our new economist Hermione Taylor delves into how pricing can make some companies more resilient when their costs are soaring.