Central Banks Facing the Double Challenge: Curbing Inflation and Avoiding Recession

Central banks have escalated their fight against hyperinflation by raising interest rates, a necessary measure despite analysts warning of its potential side effects, most notably pushing economies into recession.

Last week alone, the US Federal Reserve announced the largest increase in interest rates in nearly three decades, while the Bank of England raised them for the fifth time in a row, and the Swiss Central Bank raised them for the first time in 15 years.

“This week is unprecedented, the craziest I’ve had,” says Frederic Ducruzette, chief economist at Pictet Wealth Management.

The measures shook stock markets, with investors fearing that the wheel of economic growth would be halted if it were tightened further, despite their recognition of their importance.

For his part, says Craig Erlam, an analyst at the OANDA online trading platform, that “the possibility of a recession is increasing as central banks race to raise interest rates significantly so that inflation does not get out of control.”

Nevertheless, the Capital Economics research group says it does not expect a recession in the United States.

The group states in a note that “the Federal Reserve is deliberately easing demand in order to reduce price pressures. This is a bumpy path and it is clear that there is a risk that could lead the economy into recession.”

Emerging countries can be collateral victims of rising interest rates, as the dollar increases in value when the Federal Reserve raises interest rates.

“The rise in the dollar will complicate (paying off debt) countries that suffer from deficits and often borrow in that currency,” Decrozette explains.

Surprise in Switzerland

Central banks last year asserted that inflation was “situational” because prices were driven by disruption to supply chains after governments ended lockdown measures.

But energy and food prices rose in the wake of Russia’s invasion of Ukraine, driving up inflation and prompting economists to cut their global growth forecast for this year.

This left central banks with no choice but to act more aggressively than they intended.

In this context, the Reserve Bank of Australia raised interest rates more than expected earlier this month while Brazil last week raised its benchmark interest rate for the eleventh time in a row. More increases are on the horizon in the US and Europe.

But it was the Swiss National Bank that caused the biggest surprise on Thursday when it announced an interest rate increase of 0.5 percentage point, the first since 2007.

The Swiss bank had previously focused on avoiding an appreciation of the franc too much.

“The SNB’s decisions are attracting interest as they represent an important shift in its policy,” said Michael Hewson, chief market analyst at CMC Markets UK.

The European Central Bank has moved slower than its peers, and has announced that it will end its massive bond-buying plan and raise interest rates at the end of next month for the first time in a decade.

The eurozone faces another problem: interest rates for governments willing to borrow have risen while charging a premium to heavily indebted countries like Italy compared to Germany, which is a less risky bet for investors.

This revived memories of the debt crisis in the euro zone, prompting the European Central Bank to hold an emergency meeting Thursday, which said it would design a tool to prevent further pressure in the bond market.

On the other hand, the Bank of Japan bucked the global trend on Friday by sticking to its decision not to raise interest rates, which led to the yen approaching its lowest level against the dollar since 1998.

But even the Bank of Japan can adjust its policy, according to Stephen Innes, an expert at SBI Asset Management.

“While they plan to maintain the current easing policy, they may consider making some adjustments to support the currency,” Innes says.

No instant solutions

Consumers will have to be patient before they see the impact of higher interest rates on prices.

“Do we expect the rate hike in July to have an immediate impact on inflation?” European Central Bank President Christine Lagarde said frankly when announcing the timetable for an interest rate hike next month. The answer to that is no.”

Central banks do not control some of the problems that drive up inflation, such as skyrocketing energy and food prices and supply chain disruptions.

Capital Economics shows that energy and food prices accounted for 4.1 percentage points of the 7.9 percent rise in consumer prices in major advanced economies over the past year.

It expects oil, gas and agricultural prices to start falling later this year, which will lead to a sharp drop in inflation, but core inflation rates that do not include food and energy will remain high.