All eyes are on interest rates because, rightly so, they are the biggest macroeconomic known unknown the world faces in 2023. This week the picture became even more uncertain as financial markets initially interpreted US Fed chair Jerome Powell’s latest comments as dovish, but ongoing evidence of a rampant US labour market suggested even more rate hikes may be necessary.   

Labour markets are the last man standing in the battle to bring down inflation to pre-Covid levels of about 2% in the US. The latest jobs data came in way above expectations, with non-farm payrolls increasing by more than half a million versus the less than 200,000 jobs expected. The unemployment rate fell to its lowest level of 3.4% in more than half a century, when it was expected to increase to 3.6%. 

The Federal Reserve Bank of Atlanta president, Raphael Bostic, responded to the surprise numbers by saying the jobs report raised the possibility that interest rates would need to increase to a higher peak than expected. Powell this week concurred that the central bank would need to implement further rate increases and “we think that we’ll need to hold policy at a restrictive level for a period of time”. Economists are predicting the terminal US Fed fund’s rate may be 6% before interest rates move sideways or lower. 

However, equity markets latched on to Powell’s acknowledgement that the disinflationary process had begun and played down his warning that the road ahead is by no means likely to be easy by saying: “This process is likely to take quite a bit of time; it’s not going to be smooth, it’s probably going to be bumpy.” 

Before the data, the prevailing view was that there would be two more 25-basis point hikes before the Fed pivots to an easier monetary policy stance because inflation has shown convincing signs of slowing. Expectations are holding out for possible rate cuts before the year is out. 

Globally, and based on what is currently known, the International Monetary Fund (IMF) foresees global growth coming in at 2.9% in 2023 — 0.2 percentage points higher than its previous October forecast. But the fund did acknowledge that risks are to the downside and that tighter monetary conditions and lower growth could potentially affect financial and debt stability. 

Thus, the outlook remains tremendously uncertain, both macroeconomically and geopolitically. Most concerning is that the greatest risk is that central banks will overdo it on the monetary policy front by increasing rates too far — to the extent that unnecessary damage is inflicted on economies already feeling the dampening effects of the previous rate hikes. 

In recent research, Oxford Economics delves into the risks of what it describes as “monetary policy overkill” in developed economies. It concludes that the risk of the central banks going too far remains significant and may already be playing out. It defines monetary overkill risk as “tightening in excess of that needed to return inflation to target, implying large unnecessary output losses”. 

There is increasing evidence that the economic impact of steep interest rate increases is already becoming apparent in the US. Over the past few months, economic indicators, such as real personal consumption, industrial production, manufacturing, and trade, which were holding up well, have begun to deteriorate. 

According to the editor and publisher of Acheron Insights, Christopher Yates, coincident indicators, which reflect what is happening now, are beginning to align with what leading indicators of the business cycle have been showing for some time, namely the US is, indeed, heading towards a recession. 

Oxford Economics’ lead economist, Adam Slater, cautions that central banks may be paying too much attention to tight labour market statistics, which are lagging indicators and have been mixed recently. Also, he says there are signs of easing in the labour market data, particularly job quit rates — which signal there are inflation pressures when they increase, and have been coming down since March last year. 

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Improved global outlook

For now, however, the global outlook is looking better than back in October according to the IMF’s latest World Economic Outlook. Globally, and based on what is currently known, the IMF foresees global growth coming in at 2.9% in 2023 — 0.2 percentage points higher than its previous October forecast. But it did acknowledge that risks are to the downside and that tighter monetary conditions and lower growth could potentially affect financial and debt stability. 

Slater sees two main risk areas that lie ahead. The first is that monetary policy becomes excessively tight and leads to substantial losses in economic output. The second is that the speed of tightening results in financial market instability that feeds back into the real economy. He says while neither of these is “flashing red”, there are definite warning signs, including the rapid slowing in money growth and easing long-term inflation expectations, and that these suggest that policy may already be too tight.  

According to his analysis, which takes into account a range of technical measures in the developed economies, the US faces the greatest risk of monetary overkill, followed by the UK, the eurozone, and Canada. 

South Africa would inevitably suffer from monetary overkill in these developed regions. It will feel the direct impact if the SA Reserve Bank follows in the Fed’s footsteps and keeps interest rates rising and high for longer, as it has done to date. It would also feel the indirect effect of a worse-than-expected growth outlook and the accompanying risk-off attitude that keeps investors away from investing in the local financial markets.   

This is against the backdrop of a domestic economy already buckling in the face of ongoing and intensive rolling blackouts and contractions in the mining and manufacturing sectors. The IMF factored these headwinds into its 1.2% projected growth for South Africa in 2023, still 0.1% higher than its October prediction. But it highlighted weaker external demand, power shortages and structural constraints as problems. Thus, if monetary overkill in developed markets does unfold, even this forecast could prove too optimistic. DM/BM