The Bank of Canada and US Federal Reserve hiked interest rates this year. Many hoped that this aggressive move would cool inflation. However, this did not prove to be the case.
So why haven’t higher rates done enough to fight inflation, and what’s expected in the months to come?
The Results of Aggressive Interest Rate Hikes
Canada’s overnight and US Fed Funds rates rose from 0.25% to 3.25% at the beginning of 2022. Yet this aggressive rate hike resulted in little negative impact on the economy and job markets. Inflation cooled just a fraction of anticipated results, which, unfortunately, is considered a bad piece of news.
Marginal cooling inflation means more hikes to come, and higher interest rates generally lead to a period of recession.
It’s simply not enough to rely on higher rates because higher rates alone won’t impact inflation. However, due to decades of loose monetary policy, it’s not hard to understand why so many held onto the belief that the Fed would lower rates by 2023. After all, it’s people who must also take the situation seriously to change the tone and mood of the markets.
In other words, while the central banks acted aggressively, consumers, employers, and markets assumed the Fed would quickly lower rates. But unfortunately, this did not happen as expected.
Three Crucial Rate Conditions
In the last few weeks, three crucial rate conditions have come into play.
1. Above Neutral Rates
Current rates sit above neutral, and above neutral rates typically result in tighter financial conditions. Tighter financial conditions sit alongside a lower appetite for risk and spending. However, because September rates rested below neutral and current rates rose aggressively, it helps to explain why the economy remained strong and inflation did not cool.
2. Rates Expected to Remain Higher for Longer
There’s a consensus across the board that rates will remain higher for longer, which means the start of 2023 will likely continue to see high rates that will begin to lower.
3. Hawkish Tone Leaves Consumers and Employers Cautious
Financial hawks tend to favor higher interest rates to keep inflation in check. As of late, the central bank’s tone reflects these types of policies, leaving consumers and employers hesitant to make riskier financial decisions.
These important conditions should help fight inflation, resulting in incremental but positive results in the coming months.
What Lies Ahead?
It seems likely that the part of the market correction where it’s consistently headed for “lower lows” is over. However, there’s no doubt that markets will see more volatility in the months ahead. But the good news is that expected returns for the 3 - 5 year horizon will improve for risk taking.
Over the next few weeks, the impact of the three crucial rate conditions will become more transparent, and these insights will help to shape the financial landscape into 2023 and beyond.
Higher interest rates aren’t enough to fight inflation. However, three crucial rate conditions including above neutral rates, rates remaining higher for longer, and the central bank’s hawkish tone, will help to make incremental but positive results in the coming months. As a result, while market volatility lies ahead, risk taking should improve within the 3 – 5 year horizon.