Tensions, plot twists, decision-makers under pressure, everyone else on tenterhooks – for anyone following the monetary policy decisions of the major central banks this year, it has been a bit like watching a TV drama. The context is entirely novel. Record inflation has inevitably led those institutions to incrementally raise their interest rates by levels unprecedented in recent decades. The Fed, America’s powerful central bank, has raised its benchmark interest rate five times since March, from zero to over 3%, a trend that will likely continue over the coming months. That’s because Fed chair Jerome Powell is determined to do whatever it takes to curb inflation in the United States. In September, the year-on-year price increase there amounted to 8.2%, barely less than the 8.3% year-on-year increase recorded in August.

A buzz of activity

Recent weeks have seen increased activity. A 0.5% rate hike by the Reserve Bank of Australia on 6 September was followed by a 0.75% hike by the Bank of Canada the next day. The European Central Bank (ECB) also raised its policy rate by another 0.75% on 9 September, and the Fed followed suit on 21 September. The Bank of England then raised its key interest rate by 0.5% on 22 September.

For the time being, this flurry of measures has not been enough to prevent noticeable price rises. The reality in the eurozone is stark – inflation reached a new all-time high of 10% in September. Only the Fed’s actions have had a somewhat positive impact on its economy. Al-though the rising dollar has reduced exports for many US companies, which are suffering as a result of the current situation, it has had an overall positive effect on foreign trade for the US, which is a net exporter of oil and gas. But the opposite situation prevails in Europe, whose trade balance is collapsing mainly due to its dependence on US oil and gas, which are paid for in dollars.

The depreciation of the euro is clearly putting a big strain on the EU: "If the euro weakens, the eurozone will continue to import inflation," says Maxime Botteron, an economist at Credit Suisse. "Current inflation in Europe is due not so much to an overheating of the economy as to rising energy prices."

There’s something paradoxical about the current situation. Central banks are now trying to strengthen their currencies, after having accustomed the markets to competitive devaluations. "After several years of competitive depreciation of currencies, we are now seeing competitive appreciation," says Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.

Heading towards recession

For many analysts, everything seems to indicate that this wide-spread monetary tightening is leading the global economy towards an inevitable recession (defined as a period of reduced economic activity characterised by a decline in a country’s gross domestic product (GDP) for at least two consecutive quarters). "There will definitely be a recession," says Ducrozet. "But it would be even worse to go through a recession without having raised interest rates."

The big question is whether the central banks, and in particular the ECB, will stay the course in the event of a drastic economic slowdown. "We believe the ECB will not turn back," says Ducrozet. "But it will probably stop at an interest rate of around 2% (ed. note: vs 1.25% currently), when recession threatens to lead to a sharp rise in unemployment."

After all, interest rate hikes have many negative effects, such as higher borrowing costs for companies and individuals, lower government bond yields and higher debt costs for governments (whose finances are often already weak). Not to mention the harmful consequences for the financial markets, as the major stock exchanges are none too pleased at the prospect of a recession combined with persistent inflation. Since the start of the year, the correction of the Dow Jones, the S&P 500 and the Nasdaq is respectively -20%, -25% and -30% (as of 15 October), to name only the major US indices, which dictate the markets’ mood.

Ups and downs

Given the current climate of uncertainty, experts expect to see high volatility with strong fluctuations on the markets in the coming months. For some of the bolder and more savvy investors, this situation could be a boon. Economist Marc Touati summed things up in an article published on the website of the French magazine Capital on 8 September: "Stock markets will remain turbulent, alternating between crashes and periods of recovery, weathering choppy waters, jostled by explosive ups and downs."

Support and opposition

A number of prominent voices are speaking out in response to these events. Some are encouraging the central banks to continue to combat inflation, while others are arguing that the restrictive policies are ineffective at best and destructive at worst. Politicians and institutional leaders (current and former) are weighing in, as are economists, writers and many more besides.

On 27 August, at an annual gathering for central bankers in Jackson Hole, German economist Isabel Schnabel, a monetary hawk, said that "sacrifices" need to be made, and that rising prices must be combated "even at the risk of lower growth and higher unemployment." Joachim Nagel, president of the Bundesbank, expressed similar views a few days later, on 31 August: "We need a strong rise in interest rates in September. And further interest rate steps are to be expected in the following months," he warned. On 7 October, Kristalina Georgieva, managing director of the International Monetary Fund (IMF), reinforced this point: "The central banks need to stay the course and do more" to combat persistent inflation, she said in an interview with Agence France-Presse.

Outside of official bodies, Paul Krugman, winner of the 2008 Nobel Prize in Economics, who is usually a proponent of accommodative monetary policies, said at a conference organised by the ECB that he too is in favour of higher interest rates, invoking the "precautionary principle". Economist Jean Pisany-Ferry summarised these positions in the French business newspaper Les Echos on 19 September: "No economic model advises having a key interest rate around 1% when inflation is close to 9%."

In the other camp, several former or current leaders are voicing their scepticism. In an essay published in mid-September by the Peterson Institute for International Economics, Maurice Obstfeld, former chief economist of the IMF (until October 2018), warns: "The present danger [...] is not so much that current and planned moves will fail eventually to quell inflation. It is that they collectively go too far and drive the world economy into an unnecessarily harsh contraction.”

Within the official sphere, criticism came from of the head of European diplomacy Josep Borrell, on 10 October during a speech to EU ambassadors, leaving an impression: "Everyone has to follow the rate hikes decided by the Fed, otherwise the currencies will be devalued against the dollar," he stated. "Everybody is running to increase interest rates, and this will bring us to a global recession."

The United Nations Conference on Trade and Development (UNCTAD) also voiced its concerns in a statement dated 3 October, warning of a global recession induced by current monetary policies. Vitor Constancio, a former member of the ECB’s Executive Board and an active Twitter user, is also calling for prudence and progressiveness. The Portuguese economist is critical of the ECB’s action and says that interest rates are not a suitable instrument for responding to supply shocks such as the EU’s current energy crisis, and that this policy will not have an impact on energy prices or the prices of goods containing imported components. 

In the same vein but in more vindictive language, French writer and economist Jacques Attali drove the message home in an article dated 7 September: “Today’s inflation has no monetary origin; to try to curb it by raising interest rates, as central banks are doing and will continue to do, is suicidal. All in all, this will lead to a downward balance of supply and demand, dragging the economy into a recessionary spiral, when what is needed is a massive boost to investment in the sectors of the future, with very low interest rates.”

This line of reasoning is starting to resonate across the Atlantic, even though the respective situations of the EU and the US are not comparable. In an open letter dated 10 October, Cathie Wood, star investor and founder of the investment management firm Ark Invest, says the Fed is making a serious policy error that will cause deflation. She argues that the Fed is focusing on employment and inflation, both of which are lagging indicators, and that it should instead be focusing its attention on soaring commodity prices.

Central banks all bearing their own cross

While all central banks are looking to control inflation, they don’t all have the same means to do so – far from it. In the rate hike race, the Fed is one of the only actors that has a few powerful advantages. Its actions have started to bear fruit in recent weeks, with inflation inching downwards in the US (8.2% at the end of September). The global economy is highly dependent on the dollar and hangs on the decisions of the US central bank. Everyone is eagerly awaiting 2 November, when the Fed will likely announce another rate hike.

By comparison, the ECB is in a complicated situation with no happy outcome, according to experts. If inflation in the eurozone is not due to tensions on the labour market but to a supply shock linked to the energy crisis, then interest rate hikes – and therefore lower demand – will not help solve the problem. It looks like the ECB will ultimately have no choice but to ease up on its monetary policy in order to avoid an overly harsh recession.

The situation isn’t any better for the Bank of England (BoE). Since the government’s announcement of controversial budget measures in late September, borrowing costs for the British government have soared. Faced with the sharp drop in the sterling over the past year, the BoE has also introduced a restrictive monetary policy and raised its interest rates. As for the Reserve Bank of India, it is also unable to stop the historic fall of its currency, the rupee, against the dollar, despite a new monetary tightening at the end of September and a massive use of foreign exchange reserves.

China and Japan, the two other economic heavyweights, are continuing to pursue a completely different monetary policy strategy. They are maintaining very low interest rates –    with China even reducing them –    despite inflation, so as to avoid affecting growth. The problem, however, is that the yen reached a new all-time low against the dollar on 20 October, making Japanese imports more expensive. The situation is the same for the yuan, which reached its lowest level versus the dollar since 2008 on 25 October.

The SNB’s enviable status

Where does the Swiss National  Bank stand in all this? While it does not have the power to lower energy prices, it is nevertheless able to contain inflation in Switzerland and neutralise the impact of the strong dollar – unlike the ECB – making energy imports less expensive thanks to the strength of the Swiss franc. Although the decline in the euro versus the Swiss franc is collateral damage from the SNB’s interest rate rise, the central bank decided it would rather combat inflation through currency appreciation. On 16 June, it surprised everyone by raising its key rate by 0.5% before the ECB did so, putting the euro/CHF pair under pressure. The SNB’s leaders said they intend to continue on that path, even stating in mid-September that: "If the Swiss franc were to weaken, we would consider selling currencies."

Is the ECB worried that this could potentially cause the euro to tumble? Maxime Botteron of Credit Suisse says: "The ECB’s monetary policy has a much greater impact on the SNB’s monetary policy than the other way around, due to the impact that the EU and Swiss economies have on one another. The SNB is also clearly more dependent on external factors, over which it has no control, than the ECB and the Fed. Its actions have less of an impact on the markets."

This situation explains why the SNB is seeking to give itself some leeway: it operates discreetly, which makes its policy difficult for the markets to predict. At Pictet, Frederik Ducrozet specifies "The SNB’s policy is dictated by domestic considerations. The fact that it meets only once every quarter doesn’t make things any simpler. It may decide to raise its rates by a greater increment in one go."

Ducrozet’s last remark appears to suggest that the SNB is in a very comfortable position: "We are sceptical as to its strategy which involves potentially intervening in the foreign exchange market. With inflation at just 3.5%, is an even stronger Swiss franc really necessary?"