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Uncertainty and Volatility, the New Normality

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Uncertainty is creating volatility, the war in Ukraine, the crazy Trussonomics scenario in the UK, China’s continuing zero covid policy and US mid-term elections are just the tip of the iceberg. The world today seems, to me, absolutely bonkers and makes it very difficult to see a clear path ahead.

I did write in my most recent article that inflation in Ireland, Europe and the US while running at record levels, recent figures (ECB forecast year end annual inflation of 8.1% down from 10.7% with the FED predicting annual inflation of 7.7% compared to 8.2%) suggest that it has peaked and decelerating due to aggressive interest rate hikes by the FED and the ECB, this does seem to be the case based on recent reports by both parties and independent economists.

Whilst there is or was a need to increase interest rates to battle inflation my concern is whether central banks globally are over-tightening in particular the ECB and the FED in their attempts to get to the holy grail of 2% target in such an aggressive manner, is causing economic damage. The ECB’s and we could conclude, the US’s primary objectives are to maintain price stability, ultimately preserving the purchasing power of their currencies. In fairness price stability does create conditions for more stable economic growth and a more stable financial system but I would argue this would apply under more normalised conditions.

Blackrock Investments opinion:

“Bringing inflation down to 2% targets will mean significant economic damage, in our view. Why? There’s constrained production capacity in developed economies. The labour market and consumer spending patterns in developed economies have not fully normalized. The result: a mismatch in supply and demand, particularly in the services sector”.

In Ireland this impacts even more so on the construction sector, demand remains dramatically high while supply is low and reducing. The Irish Times headline “Construction activity shrinks amid cost concerns” highlights that residential units being developed are down 10%, driven by a drop in apartment starts. Two main factors driving this reduction are cost uncertainty as material and labour costs remain volatile and the unpredictable nature of funding which has been driven by the movement of institutional investors to change their investment strategies.

The holy grail of 2% inflation which is optimum for a balanced economy is not really possible in the current uncertain and volatile world we live in, the current thinking by central banks of fast and furious interest rate hikes is to crush demand, reducing employment which in turn should reduce inflation, but the downside may cause a recession. The medium to short-term goals should be more balanced, a leveling off, lower increases or a halt to increasing interest rates is paramount, we need to see if these hikes have already taken hold as further increases particularly high raises could unintentionally push the globe into a much more protracted recession, than is required. If this were to happen then this would leave central banks with very little ammunition to rectify the situation, such as reducing interest rates and reverting to quantitative easing to counteract such a problem.

A protracted recession with depleted central bank arsenal leaves highly indebted countries open to the debt markets, that is government bonds start to become too expensive leaving them to struggle to refinance their ongoing debt needs. On top of this we could also see a period of stagflation, “The danger of stagflation is considerable today,” the World Bank warned this week. “Several years of above-average inflation and below-average growth are now likely.”  

Economic slowdown, increased unemployment with consistent high inflation, this is all down to timing effects of monetary policy while so many other elements are outside of central banks control, such as the bottle necks of increased price of gas, ongoing supply shortages in construction, chip manufacturing, labour, etc driving up costs. Could we be looking at another 1970’s type of shock whereby high interest rates caused a major recession followed by country debt crises, I hope not and the thinking is central banks have actioned solutions much quicker this time around. The tightrope they are walking now is wobbly – let’s hope they can maintain their balance.

Colm McGrath, Managing Director, Surety Bonds
(This article first appeared in Irish Building Magazine Issue 4 – 2022)