The tide has turned in recent months, with financial markets now expecting central banks to raise key interest rates multiple times to counter rising inflation. But we need to remember that hiking interest rates isn’t a magic bullet. It’s hard to fight supplydriven inflation like we have today. Goods and services production in many countries is still limited by public health measures and other pandemic effects. Raising interest rates in this climate won’t help address supply issues. Lifting public health measures as the pandemic recedes would be more effective.

Interest rates mainly impact demand. Raising them would essentially curb consumption and investment. It could help lower inflation, but it would also slow the economy (Chart 1). In the worst-case scenario, continued weak supply combined with demand constrained by multiple interest rate hikes could trigger a recession in early 2023.

According to a recent Bank of Canada survey, business investment prospects are very good despite labour shortages and strong demand. But a sharp rise in interest rates could slow demand and significantly increase borrowing costs, which could dampen investment.

High debt suggests greater sensitivity to interest rates

The risk of a severe economic slowdown or even a recession also increases with interest rate sensitivity. Although it’s tough to accurately measure sensitivity, we know it increases with debt, and the debt burden has only increased in recent years. The pandemic obviously hasn’t helped, especially when it comes to government debt (Chart 2). Governments could see their borrowing costs go up faster. To compensate, some may be tempted to cut spending or increase revenue.

In recent years, ultra-accommodative monetary policies have helped raise the valuation of various asset classes. Reversing these policies too quickly could significantly reduce the value of financial assets such as stocks and bonds. Rate hikes could also hurt real estate values.

Risk of widespread financial instability

There’s also a risk of widespread financial instability. Financial markets don’t perform as well when volatility is high. Companies and financial institutions could find it harder to refinance, potentially leading to more bankruptcies. An increase in risk premiums, exchange rate volatility and international capital movements that disadvantage certain countries could further aggravate financial instability. Besides hiking interest rates, central banks may start trimming their balance sheets (Chart 3). The Bank of Canada has already hinted at this, while the European Central Bank still intends to buy assets this year. Expanding balance sheets lowers bond yields, so trimming balance sheets should raise them. This monetary tightening could steepen the yield curve further. It could also increase risk premiums.

Conclusion: Moderation is key

There are many arguments in favour of moderate key rate hikes. Central banks will likely want to play it safe to avoid sending the economy back into recession. At the same time, they’ll expect supply chain issues to clear up, which would significantly reduce inflation in the coming quarters. But to lower inflation in the past, central banks had to rein in the economy to the point where real GDP fell and unemployment rose, so we can’t rule out that possibility just yet.

Desjardins is a preeminent economic forecaster and Canada’s leading cooperative financial group. It provides financial support services to businesses looking to expand to Quebec and the rest of Canada.

Website: desjardins.com/europe
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