Image Source: Unsplash

Performances

Most strategies were in the green for July.

Rates: Inflation vs. Recession

For July, the Federal Reserve raised interest rates by another 75 basis points (bps), taking the fed funds rate to 2.25%–2.50%. A few days before this, the ECB hiked rates by 0.5%, lifting them from the previous -0.5%. This was the first time the ECB raised rates in 11 years.

These are actions that the central banks are forced to take to be able to tackle the risk of runaway inflation. Normally a ‘soft landing’ is what the Fed would want.

Imagine a very simple model: Raising rates crash the market and lead to recession, but they also contain inflation. Lowering rates (or not raising them fast enough) helps growth and investment, but this also leads to runaway inflation.

What a central bank would want to do is small, expected rates hikes that would cause controlled, mini market crashes. This would somewhat contain inflation and not lead to a large recession. In some ways this is what is happening now. We have a moderate 15% correction in equities while rates crawled up to 2.25%. The markets expect the Fed to reach a terminal 3.5% target.

In the E.U. and in the U.S., inflation has become a political issue so it is likely that there will be a push to contain it. The risk becomes having a political mandate that prioritizes inflation reduction rather than market growth. In other words, the Fed appears to err on the side of inflation lowering and causes a further market crash.

That said, long-term, it is in the interest of governments that we live with moderate inflation. Why? Because it is an indirect tax on people savings (and pensions), and it reduces the government debt that needs to be paid back.

More By This Author: