Inflation, central banks and interest rates: what will happen in 2023
15.03.2023
According to the experts, rates will continue to rise at a slower pace than in 2022, while we will have to wait until 2024 to see a reduction. What scenarios are opening up for investors?
In July[1], however, the Governing Council of the ECB decided to raise the three key interest rates by 50 basis points, “in line with its strong commitment to fulfilling its mandate to preserve price stability”. For the same reason, another even sharper intervention followed in September(+75 basis points), after which came a rise of 50 basis points in December. The same happened on the other side of the ocean, where the Fed also revised its interest rate policy.
In the new year, analysts and observers are waiting to see what the next moves of the European and US central banks will be. Monetary policy has an impact on the economy and, consequently, becomes one of the variables that investors have to take into consideration when planning their asset allocation.
Monetary policy: the impact on the economy
Monetary policy is the set of money supply and interest rate choices that are generally made by a state’s central bank to achieve economic policy objectives.
In Europe, with the Economic and Monetary Union, the Member States have delegated this task to a single institution in practice: the European Central Bank. As clearly stated[2], it has the principal task to keep prices stable, in favor of economic growth and employment.
As explained by the ECB itself, in fact, its objective is solely to “preserve price stability by ensuring that inflation remains low, stable and predictable”. The mission is to achieve an inflation rate of 2% in the medium term. “We pursue this goal symmetrically: for us, overly low inflation is just as bad as overly high inflation” explains Europe’s top banking supervisory body.
When a recession or crisis marks the economic environment, as was the case after 2008–09 and after 2012, the response of central banks is usually to adopt an expansionary monetary policy. By reducing key interest rates and buying securities, and through soft loan schemes and open market operations, central banks help to keep government bond rates low and stimulate liquidity to encourage consumption and business investment.
Conversely, when inflation is excessive or prolonged, as has been the case since 2022, prices rise so high that they erode the purchasing power of households and businesses. At this point, the central banks intervene to curb the price run with a restrictive monetary policy, which reduces the amount of money in circulation by reducing the direct purchase of securities and raising interest rates.
Balance is the key word here: an overly expansive monetary policy can, in fact, lead to excessive inflation in the medium term, while one that is too restrictive can trigger a downward spiral on the economic growth front, holding it back.
Why central bank decisions also affect investments
In fact, monetary policy plays an important role in economic system trends, households’ and companies’ access to credit, trade, and – directly and indirectly – also financial markets.
Interest rate policies influence the cost of money, and thus also the cost of public and private debt. On the financial side, this has an impact, for example, on government bond yields and, therefore, on the choice between bonds and equities when making asset allocations.
Central bank policies also condition currency exchange ratios in international markets, because higher interest rates attract foreign capital as they offer higher yields than other countries, leading the reference currency to rise. This aspect, therefore, has to be assessed with a view to the geographical and currency diversification of one’s investment portfolio.
Another key aspect is the ability of monetary policies to maintain economic stability. As explained by the Central Bank itself[3], “the financial system benefits from price stability: it is easier for citizens and companies to plan and invest knowing that prices will not change much over time”.
A symbolic case is the 2008 financial crisis, which, by disrupting the flow of money in the economy and creating unstable financial markets, led to an unstable system in which citizens and businesses struggled to access finance and, consequently, to restart the real economy. Therefore, the ECB in Europe and the Fed in the US have adopted an expansionary policy to help keep prices stable, helping the economy and the financial system to recover.
Now the international conditions are different from 2008 but no less complex. In a situation still feeling the effects of COVID, rising energy costs, and geopolitical instability, the financial market is looking closely at the policies of the ECB and FED to see if and how much they will be able to intervene to create stable conditions.
According to forecasts[4], the ECB should continue to expect a further increase in rates in 2023, albeit reduced compared to 2022, while only in 2024 could this lead to a reduction, if the measures taken in this two-year period have had their full effect and inflation has come down towards 2%.
Will this be enough to maintain market stability, considering that there are many variables affecting the stability of the system?
Certainly the rise in rates, despite being smaller, indicates that the top banking authorities still expect inflation to rise in 2023, against which solutions focused on assets such as gold – a safe haven asset par excellence – may allow portfolio diversification consistent with their objectives of capital preservation and enhancement.
[1] https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.mp220721~53e5bdd317.it.html
[2] https://www.ecb.europa.eu/ecb/tasks/monpol/html/index.it.html
[3] https://www.ecb.europa.eu/home/search/review/html/monpol-financial-stability.it.html
[4] https://www.bloomberg.com/news/articles/2023-01-30/ecb-rates-march-in-focus-after-half-point-hike-assured-this-week
