The financial markets went from a point, at the end of last summer, when they understood that interest rates would be higher and for longer than they previously thought, to a period, since November, where they now anticipate a soft landing, without a real recession, with a fairly rapid and pronounced drop in key interest rates from next March.
And recent data seems to justify this change in mood. Total inflation has fallen more than expected in recent months and, while the European economy has stalled, American growth has held up; all without a real recession. Long term rates, as well as equity markets, have thus incorporated these forecasts. This situation, if it persists, would represent a historical incongruity, because all rate increases of a comparable level of intensity have always led to recessions, which have caused inflation to fall sustainably. But the facts so far seem to confirm this possible exception. What could be the specific reasons behind such an economic resistance combined with disinflation? Firstly, the usual reaction time of the real economy after a significant tightening of monetary policy takes 18 to 24 months. We have only just reached this point. Note also that fiscal policies in Europe, but even more so in the U.S, to both protect against inflation but also to re-industrialise and make national economies more green have worked against the cycle driven by central banks monetary policy. The American public deficit in particular is historically high. Let us also add that the additional savings accumulated during the Covid period were gradually used up after the lockdowns and are as of today on both sides of the Atlantic close to being wiped out. And the spending of these surpluses supported economic activity. Finally, firms took advantage- before and during the pandemic- of exceptionally lower rates than usual to finance themselves over the longer term with fixed rates. This therefore delays the effects on the requirements of a more restrictive monetary policy because the rising interest rates take longer to bite.
But these explanations also highlight the uncertainty faced by economic players, as well as the Central banks. Indeed, the empirical deadlines for the maximum effectiveness of monetary policy should not be underestimated and lead us to anticipate a soft landing too early and with too much confidence. In addition, in Europe at least, fiscal policies- whose constraints had been suspended due to the pandemic- will begin to tighten to various degrees. And in both the U.S and certain Eurozone countries, the limits of public debt will probably begin to be felt more and more strongly on the financial markets. Central banks will gradually stop buying their government’s debt and, even with the recent drop in long-term rates, future bonds will be issued at much higher interest rates than in the last ten to fifteen years. Solvency will therefore only be held up through the announced and maintained trajectories of a return to much lower public deficits than those of the past, or even to primary surpluses, bringing public debt very gradually onto a sustainable and acceptable path. Finally future corporate refinancing will be higher from 2024 onwards, entailing a more noticeable effect of recent monetary policy.
The signs of a general slowdown, more pronounced in Europe than in the U.S though, are clear. However labour markets despite a slight dip remain tight. The Central banks have to therefore manage a situation where all the latest monthly figures are and will be decisive. The fight against inflation has taken the right path but the base effects of recent months compared to the previous year could lead to a slight increase in the inflation rate. Moreover wages are increasing at rates between 4 to 6% on both sides of the Atlantic, but with productivity growth more than 2% in the U.S compared to stagnation or even slight decrease in the Eurozone, which could slow down or hinder its underlying inflation. The latter, even if on the right track, remains quite far from the monetary policy objectives. Central banks must therefore remain very cautious about easing their directives. Equally and symmetrically they must pay attention to the return of credit defaults which will soon rise sharply. This growth in credit risk is due to rising rates as well as a period when rates were too low for too long which led to the artificial survival of businesses. A rise in defaults is therefore necessary and expected. However the effect should not be systemic. Likewise with regards to the housing crisis; the fall in prices is and will continue to be beneficial but it must not lead to a catastrophic chain of events.
In short, the Central banks will therefore have to move and act in a very uncertain world. And as is required, show their unwavering determination to bring inflation back to an acceptable level. Whilst remaining equally attentive by avoiding any situation that would induce a systemic crisis. They must therefore be alert and agile with a path, a compass which is clear and shown. For their part, the stock markets will navigate between two poles. On the one hand, the current hope of a soft landing with inflation returning to a low rate quicker than expected leading rapidly to lower interest rates . And on the other hand, the awareness that profit rates may not be able to continue their high levels due to the current slowdown in growth and that inflation, though falling significantly, will not necessarily lead to a lowering of key rates at the rhythm and intensity desired. Finally the markets will have to accept that long term interest rates must sustainably remain at a level significantly above those of the pre-pandemic. Without forgetting geopolitical developments which have had very little influence on the markets until now, and the results of various upcoming elections, the year that has just begun could be more turbulent than anticipated , a comparable symmetry of the year that just ended which posted an economy that was more resilient than expected.