Photo by Etienne Martin on Unsplash

I have a few speaking engagements coming up, prompting me to update my view on the world beyond the borders of the Eurozone, which makes up the day job. One trend that I am looking forward to presenting to, and discussing with, investors and capital allocators is the tension between signs that the inflation and interest rate shocks are now fading, in a cyclical sense, and the risk that inflation will stabilise above 2%, posing a challenge for monetary policymakers. Will they channel their inner Volcker or fudge the 2% inflation target?

To set the scene on this discussion, I first have to show the premise. The jury is still out on both inflation and interest rates, but for my part, the writing increasingly seems to be on the wall. Inflation is falling, and hiking cycles are coming to an end, at least measured against their pace over the past 12-to-18 months. The first chart shows that inflation in the largest developed economies is coming off the boil. Headline inflation in the US, UK, and the EZ economies has just about halved over the past 12 months, from a peak of nearly 9% at the end of third quarter of 2022. The rally in oil prices is now threatening a rebound, especially in the US, but broadly, global energy prices would have to rally further, and stay high, to force a rebound in DM headline inflation from these levels. Crucially, core inflation is now easing too, and unless the trends in month-to-month price setting shift dramatically to the upside between now and the end of the year, further dovish CPI prints in the major DM economies are coming.

On interest rates, I was inspired by this tweet from TS/Lombard’s Dario Perkins, plotting the number of central banks hiking rates in the previous three months. This, I think, is a diffusion index taking a value of one for every central bank having hiked rates in the previous three months, and zero otherwise. So for a sample of N, the index takes a maximum value of N, when all central banks are hiking, and a minimum value of zero, when no central banks are hiking. As Dario’s chart shows, the pace of global monetary policy tightening is now fading, measured here as a fall in the number of central banks hiking. Note in this respect that a value of zero for any given central bank could signify either no change in interest rates or a cut. So, if by the end of the year, no central banks are hiking on a three month basis, which seems reasonable, the line drawn by Dario will go to zero.

The chart described above is one example of an interest rate diffusion index, which is a type of model that comes in many shapes and sizes. I worked with them extensively earlier in my career as Head of Research for Variant Perception. The chart below plots the normalised index of two diffusion indices of 36 global policy rates pushed forward nine months alongside a measure of global economic activity, here the global composite PMI. The first diffusion gauge is the number of central banks in the sample hiking on a six-month basis, and the second is the difference between the number of hikers and cutters, also on a six-month basis, to give some weight to an increase in the incidence of interest rate cuts.

The charts shows why macro investors would be wise to keep an eye on the global interest rate cycle as a leading indicator for economic activity. Periods of global tightening has consistently been associated slowing economic activity, with a lag of anywhere from 9-to-15 months. By contrast, periods with no tightening has, more often than not, been associated with general expansions in global economic activity. Note that this model is based on the idea that economic activity reacts to the change in the pace of policy tightening, not the overall level. It can’t evaluate the potentially tightening effect of higher-for-longer.

What is the model telling us about the global economy right now? I guess it depends on your perspective. One interpretation of the picture above is that the drag from rising interest rates on economic activity is now peaking. Judging by the most recent shift in inflation, and expectations for major central bank policy, the blue line will almost certainly rise further in the next three-to-six months, adding to the feeling that the drag from monetary policy tightening has turned a corner. By contrast, the chart also shows that cyclical lows in the PMI tends to occur in the early periods of fading policy tightening, consistent with central banks taking the foot off the pedal as growth becomes more vulnerable. From that perspective, we would conclude that the rise in the PMI earlier this year was a head fake, and that new lows beckon in the next three-to-six months. I think this story will dominate in the near term. Interest rates will stop rising, and questions will turn to whether central banks have over-tightened as inflation comes down and growth falters. We could even see rate cuts by key central banks at the start of next year.

But I don’t think we’re facing a situation similar to previous instances of rising interest rates in which growth, and asset prices, go up in flames, rates go back to zero, QE is restarted and central banks clock up (yet another) policy mistake on their file. This is because the global economy post-Covid and the war in Ukraine has transitioned to a more inflationary equilibrium due to activist fiscal policy, inflationary geopolitics and labour markets which will not be allowed, mainly due to fiscal policy, to suffer on the altar of bringing inflation down. If this is true, and this admittedly is a big if, central banks will face an interesting choice at some point next year as (nominal) economic growth rebounds with inflation either still above or very close to 2%. Do they re-tighten or live a little? To me that is the big difference between a soft and a hard landing.

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