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2022 - the return to normal for central banks?

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2022 – the return to normal for central banks?

In 2020 the pandemic hit. The world as we knew it was turned on its head. Stock markets suffered some of their steepest falls in years – they also experienced some of their quickest recoveries.

Moving into 2021, it was all about the economic recovery, and with this appearing to be heading in the right direction, it’s expected 2022 will be the beginning of the end – a return to some form of normality – particularly when it comes to central banks and their monetary policy.

For many of the world’s major economies, 2022 seems to be shaping up to be a year of transitioning away from the unprecedented levels of fiscal stimulus and support brought in during 2020. The year will involve walking a delicate tightrope: gradually moderating the level of support in place, but not so much to undo the economic growth we experienced during 2021.

Perhaps one of the most asked questions by investors this year will be how much will we see a shift back to normality when it comes to monetary policy? And how will it impact on stock markets?

In February’s Skipton Insight we explore the path central banks could take with monetary policy this year. We particularly focus on how the US Federal Reserve (Fed) may choose to act – given this is the world’s largest economy, meaning global markets pay a lot of interest to what happens over the pond. Importantly, we’ll also explore what a tightening of monetary policy and interest rate hikes could mean for your investments.

Inflation is a key player

In 2020, there were 207 interest rate cuts from central banks around the world, against just nine increases. 2021’s transition into the recovery can be seen through the switch to only 13 rate cuts and 113 hikes. But, notably, it’s only the Bank of England out of the big five which took action in 2021.

For many developed markets across 2022, how they decide to act relies heavily on inflation – the measure of overall price rises in the economy.

It’s almost impossible to not have noticed that inflation is soaring. Here in the UK, there was a collective wince when inflation rose to 5.4% in December – the highest level in almost 30 years. And in the US, it hit 7.0% – meaning prices rose at their fastest rate in nearly 40 years.

For the most part of last year, central banks were of the view that high inflation was transitionary, but as 2021 drew to an end and inflation continued to climb, officials began to change their tune slightly. It’s become more accepted that inflation levels are more rooted that first hoped, and that numbers will stay high into much of 2022.

Typically, inflation is self-regulating; if prices rise too fast and impact the purchasing power of households, then this naturally leads to a slow in consumer activity. The issue is that the inflation we’re seeing today is less of a problem of excess demand and more to do with supply and staffing issues. As has been for some months now, shelves have been slightly emptier in the shops, delivery times have been a little longer, and then there’s the ongoing energy crisis which has seen prices soar.

So the questions is, how much longer are central banks prepared to let inflation run a long way ahead of interest rates for?

In the main, central banks seem to be of the view that supply issues will ease slightly across 2022 and there is evidence to support this – after a near five-fold rise from pre-Covid levels, shipping costs have started to come down slightly. But nevertheless, it looks like there could still be at least six months of high inflation ahead of us.

The Fed is concerned enough to have accelerated the scaling back of its bond purchase programme so that this comes to an end in Spring, opening the door to interest rate hikes later on in the year – Goldman Sachs predicts there could be as many as four hikes across 2022.

Here in the UK, the Bank of England increased the base rate in December, from 0.1% to 0.25%. It’s the first-time rates rose in three years, and it’s expected the Bank may complete a further two rises in 2022. In the Eurozone and Japan, inflation pressures aren’t as concerning, meaning rates are unlikely to even rise this year.

What does all this mean for investors?

As long as central banks don’t shock investors with their actions, markets should be able to handle rate hikes without too much panic. The main threat comes in the form of inflation – it could cause central banks to act sooner than what they have set out.

It’s important central banks are transparent about how they plan to carry out their business. Back in 2013, markets panicked because the Fed failed in its communications over rising interest rates and caused a sell off amongst investors – even safer government bonds.

This time around – so far – the Fed appears to have learned its lesson and is trying to be as clear as possible in its messaging. Even so, it’s likely there will a few wobbly moments over the coming months.

For example in early January, minutes released from the Fed’s December meeting revealed officials were concerned about rising inflation, and as a result notes hinted that monetary policy could be tightened even faster in order to combat rising prices – these are comments markets didn’t react well to.

Perhaps the most direct effect of interest rate hikes will be on the price of fixed-income investments, like bonds. Higher interest rates mean the return from risk-free assets like cash should rise, and as a result, investors demand a higher return from bonds to compensate for the further risk to their money – meaning bond prices will fall.

The International Monetary Fund warns emerging markets could suffer too. Countries could see their currencies de-valued once the Fed start to tighten monetary policy – this would prove particularly troublesome for countries with large debt or high inflation.

In terms of share prices, it’s hard to predict – as with all things stock market related. Historically, interest rate rises haven't been good news for share prices, which is why markets tend to react badly to the prospect of sooner than expected rate hikes. However, it’s important to remember there are areas which are likely to benefit from rate rises too, such as financial companies like banks.

Mark Butterworth

Currently, stock markets appear relatively calm at the prospect of interest rate rises – perhaps this is because investors know they are an eventuality and, as discussed, central banks are being clear about this. It’s also wise to consider that even with hikes, in comparison to historical levels, interest rates are set to remain low – and in some cases below pre-Covid levels.

Mark Butterworth, Head of Financial Advice Planning and Research

The beginning of the end

All in all, 2022 will see a less supportive backdrop in terms of monetary support and interest rate policy, but there’s no doubt central banks will be cautious of too rapid a normalisation in order to avoid a short sharp shock to markets and to prevent any disruption to the ongoing economic recovery. Rather than a return to normality, we’re likely to see a turn towards the new normal – if anything it’s only the beginning of the end for central banks, who still have a long way to go with their policy making in a post-Covid world.

Mark concludes, “The main point to take away as an investor is that although interest rate hikes are pretty much nailed on, levels will still remain relatively low over the course of the year – and likely the next few – and any hikes should be gradual and priced in by markets.

“The only certainty over the last couple of years has been uncertainty, and there will be more of the same this year. That’s why it’s important to remain committed to your long-term goals and keep in mind the diversified approach your take through your investments with Skipton.”

Economic and market conditions experienced in the past may not be repeated in the future. The opinions and analysis provided are for information only and do not constitute financial advice.

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