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Executive summary
- Traditional macroeconomics states that higher interest rates act as a brake on economic activity. But the ongoing strength of the US economy, despite a significant rate hiking cycle, appears to have convinced many market participants to embrace a kind of ‘anti-economics’ – the idea that significantly higher rates can quell inflation without harming growth.
- However, central bankers, burned by their flirtation with ‘anti-economics’ in the form of the ‘transitory’ inflation mistake of 2021, have been at pains to stress that this time they are sticking to traditional economics. As a result, they have consistently signalled that weaker macro outcomes, particularly relating to the labour market, are necessary to get inflation under control. We believe this thinking is shaping the current “higher for longer” message.
- The ongoing strength of the US labour market, as evidenced by the September non-farm payrolls report, and the potential for recently rising oil prices to add to inflationary pressures as a result of conflict in Israel and Palestine, are among the factors likely to keep the Federal Reserve hawkish.
- We believe that the gravity of restrictive interest rates will eventually have its intended effect on growth and the labour market, meaning that the US will enter a recession in the next 6-12 months.
- The situation has been complicated by the delay in the transmission of higher rates into the real economy in the US. However, in Europe, particularly in the euro area, higher interest rates are passing into the real economy, solidifying our conviction that Europe will fall into a recession over the coming quarters.
- In China, policymakers are fighting traditional economics. While a severe negative growth shock remains unlikely, structural problems with the property sector and local government finances will weigh on economic activity and mean that stimulus will be incremental and targeted.
- Finally, Japan has been living in an ‘anti-economics’ world for some time. While interest rates cannot remain negative indefinitely, contrary to market expectations, we believe the Bank of Japan will wait until the shunto wage negotiations next year before making major changes to interest rates. That said, an overshoot in US yields may change the trade-offs for the central bank, particularly as it relates to YCC.
The universal attraction of gravity
Einstein’s theory from 1915 remains the most apt description of gravity we have today. In it, Einstein postulated that all mass reacts the same way to gravity. However, the existence of antimatter, unknown to Einstein then, which has a completely opposite internal structure to matter, raised questions in the scientific community about whether it would interact with gravity in the same way as matter does.
Matter is, of course, attracted by gravity (why we fall back towards the ground when we jump). Given the opposite structure of antimatter, it was sensible to think that perhaps gravity repels antimatter. But in an experiment carried out at CERN1, scientists managed to produce anti-hydrogen atoms and demonstrate that they too dropped towards the ground, confirming Einstein’s theory that all mass (irrespective of its internal structure) responds to gravity in the same way.
In the world of macroeconomics, traditional economic theory holds that changes in interest rates (the gravity of our analogy) should have a predictable impact on the real economy (matter) – higher rates ought to slow economic growth as borrowing costs go up and financial conditions tighten.
However, the ongoing resilience of the US economy – and, until recently, other advanced economies – to such an aggressive hiking cycle, despite record debt levels, raises important questions about the future of the business and policy cycle, including whether the traditional rules of macroeconomics still apply.
In this GMI we seek to answer whether the behaviour of the US economy has changed so drastically that it is time to re-examine the foundational principles of macroeconomics and perhaps embrace ‘anti-economics’ (see Chart 1). Or should we trust our macro Einsteins and maintain the view that irrespective of the internal structure of the economy, higher interest rates will still have a negative impact on growth.
Put another way, can we have a costless disinflation in the face of such a sharp rise in rates, as the market seems to be pricing today?
Monetary policy transmission delayed in the US, but gravity is irresistible in the end
In the US, monetary policy has been partially blunted by the excess savings accumulated during the COVID years by households and the large amount of fixed-term corporate debt that was taken out in the immediate aftermath of the pandemic. Strong fiscal support is also playing an important role in the ongoing resilience of the economy (see Chart 2).
However, our assessment is that these factors represent a temporary shift rather than a structural change and that they will run out of steam as we move into 2024. We believe that effective interest rates will increase across the board as refinancing occurs at the new higher cost of borrowing, leading to a sharp rise in interest expenses, particularly for the corporate sector.
[1] Anderson, E.K., Baker, C.J., Bertsche, W. et al. Observation of the effect of gravity on the motion of antimatter. Nature 621, 716–722 (2023)
In addition, given the breakdown in the relationship between the fiscal deficit and unemployment in this cycle, and the political polarisation in the US, the chances of additional fiscal easing are low unless there is a significant fall in growth. Indeed, for a true soft landing to take place, we think that the Federal Reserve (Fed) will have to embrace ‘anti-economics’ – the idea that inflation can continue to fall irrespective of the strength of the labour market (see Chart 3) – and pivot from its current ‘higher for longer’ mantra.
Remember that the Fed and other key central banks attempted to embrace ‘anti-economics’ back in 2021 only to learn a humiliating lesson in traditional economics, when the transitory inflation thesis fizzled out in the face of sharply rising inflation driven by extreme supply and demand mismatches triggered by the pandemic.
Shaped by this chastening experience, we find that this time there is no evidence to suggest that the Fed or other key central banks have backed away from traditional economics, which postulates that demand side inflationary pressures are driven by demand that is in excess of the capacity in the economy (the key indicator of which is the labour market) – hence the need for a higher policy rate, in clearly restrictive territory, that remains at this level for longer. A hawkish response at the November FOMC meeting to the continued strength of the labour market (note that the September non-farm payrolls print was red hot) would show the psychological impact of the 2021 experience, in our view.
Indeed, it is the ‘higher for longer’ mantra (confirmed in the FOMC’s September dot plot) and the potential for additional hike(s), that further supports our belief that the US will enter a recession in the coming 6-12 months, particularly as some of the powerful temporary factors that are delaying the impact of monetary policy fade away in coming months. The ongoing rise in long-dated yields only strengthens our conviction as broader financing conditions tighten further.
Resilience now, fragility later – once economic gravity kicks in
Let’s now look at how higher real rates are impacting the economy. Our leading indicators are signalling that the acceleration of global growth seen so far this year is now behind us. The latest developed markets Flash PMIs show that the deterioration of growth is broadening, as the services sector continues slipping into contraction, closing the gap with manufacturing.
However, the regional divergence within developed markets – with the US and Japan on one side and Europe and the UK on the other – has widened (see our activity trackers in Chart 4). Growth in Europe and the UK is already faltering. In fact, we believe these economies will likely enter recession towards the end of this year.
In contrast, the US economy continues to perform well, despite the policy tightening to date, likely explaining why markets have latched on to the possibility of a soft landing. But as noted above, we think this strength is driven by a number of temporary factors, and ‘higher for longer’ rates will drive up the interest costs to the economy as more companies and households are forced to refinance at higher rates as we move through 2024. We believe that the key central banks will continue to view the strength in the labour market as a sign that underlying inflationary pressures in the economy have not abated and thus keep rates high (both in nominal and real terms).
Assessing policy transmission – economic ‘gravity’ is alive and well in Europe
The continuing resilience and low sensitivity to higher interest rates shown by the US economy makes it unique, raising the question of whether the policy transmission mechanism is delayed or indeed broken there. By contrast, the European economy is starting to show the strain of higher interest rates. Growth is weakening even though inflation is still elevated. While the Fed remains resolutely hawkish, the European Central Bank (ECB) and the Bank of England (BoE) are facing an increasingly consequential trade-off.
We identify two main differences between Europe and US that could be contributing to the delay in policy transmission in the US. The first relates to the nature of the credit channel itself. The euro area’s credit is predominantly bank-based. As Chart 5 shows, around 88% of corporate debt is financed through loans, with the rest being financed through capital markets. This stands in stark contrast with the US, where the majority of corporate sector financing comes from capital markets. Bank lending typically has a higher share of floating-rate debt, whereas capital market debt is predominantly based on fixed rates. Borrowers using fixed rates will only feel the impact of higher rates when they refinance, whereas floating-rate borrowers will see the impact of interest rate moves immediately.
This is borne out in the diverging trends of effective interest rates in the US and Europe. In Europe, we find that as of Q2 2023, 48% of policy rate hikes have already been reflected in the effective interest rate for the total stock of existing business loans (Chart 6). However in the US, only 26% of policy rate hikes have passed through to effective interest rates for non-financial corporate debt. We find that this slower transmission in the US is indeed due to the higher share of debt securities, whereby the increase in effective rates for investment grade bonds is less than 10% of policy rate hikes as of August 2023, and even less for high yield debt securities.
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