Mark Lister, 31 July 2022

Until now, central banks have had the luxury of a strong economic backdrop, which has meant the interest rate hikes we’ve seen so far have been taken in stride.

In addition, monetary policy has been deep in stimulatory territory, so any changes have simply reduced the level of support, rather than hit the brakes in a big way.

However, things are changing, in New Zealand and the US at least.

The biggest fall has come against the US dollar. We’re down ten per cent this year, and 17.2 per cent below last year’s peak, having fallen from US$0.74 in early 2021 to US$0.62 today.

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We’re seeing clear signs of a slowdown in activity, which means the Reserve Bank of New Zealand (RBNZ) and the Federal Reserve will be hiking into more fragile economies.

The ANZ Business Outlook survey has reflected an increasingly weak outlook in recent months, with its Own Activity measure (traditionally an accurate gauge of where growth is headed) falling to the lowest levels since mid-2020.

In the US, the latest Purchasing Managers' Index (PMI) fell below the breakeven 50-level in July. That’s the weakest since June 2020 and excluding the pandemic period, it’s a rate of contraction not seen since 2009.

Manufacturing activity looks to have stalled in the US, while the service sector’s rebound has slipped into reverse. The tailwind of pent-up demand has seemingly been overwhelmed by the rising cost of living, higher interest rates and increasingly cautious sentiment.

Surveys like these can be subjective, although they’re worth paying attention to. They’re released in a timelier manner than other statistics and they tend to be useful leading indicators as to the state of an economy.

Not only has activity slowed, but central bank interest rates are now much closer to what could be considered “neutral”. The neutral interest rate is the theoretical level where monetary policy is neither accommodative nor restrictive.

It’s difficult to pinpoint exactly where this tipping point is, but the RBNZ and the Fed see neutral as somewhere in the 2-3 per cent zone.

If that’s indeed the case, they’re already there.

Both central banks have moved swiftly from having near-zero interest rates and asset purchase programmes in place during 2021, to a halting of the latter and policy interest rates that sit at 2.50 per cent today (after the Fed’s increase a few days ago).

In theory, that means every interest rate hike from this point will push monetary policy to levels where the economy is being actively slowed down, rather than merely supported less.

Financial markets are picking the Fed Funds Rate will end this year around 3.25 per cent and that our Official Cash Rate will be close to four per cent. That’s another 0.75 and 1.50 per cent worth of respective increases between now and Christmas.

It remains to be seen how much this will dent inflation, or how economic growth and the labour market will hold up. We might even see the Fed or RBNZ change tack before then, if things start moving in the right direction.

No matter how it develops, this next phase of the tightening cycle will be very interesting. The stakes are higher, and there is much less room for error.