Are we in for a quick global recession, or just years of slow growth?

Although inflation is far from tamed, most of the central banks' major interest rate rises seem to be behind us. Now markets and investors are looking for the best way forward in this new world of tighter monetary policy.

There were some seismic shifts in the investment landscape, with bonds and cash suddenly being attractively yielding investment alternatives, while large debt piles and near-term refinancing needs have turned from commonplace to serious problem in a matter of a few quarters.

So far, markets seem to be swinging back and forth between hope and fear of the opportunities and dangers posed by this new economic environment. But beneath the noise and exuberance of market swings, restrictive monetary policy will have a long-lasting impact on growth and inflation that will shape the global economy and financial markets for years to come.

The long-term effects of interest rate rises on economic growth

Central banks are required to ensure price stability by tightening monetary policy. They do this by raising refinancing rates for corporate banks, which in turn impacts the economic behavior of financial and public institutions, as well as corporations and consumers. 

• Higher capital costs make it harder to make projects and investments profitable, so demand for corporate credit slows down. 
• At the same time, rising interest rates put a question mark on the financial viability of debt financing, which pushes banks to be more selective when lending, as overall credit risks increase. 
• Lower bank lending pours cold water on economic growth, as investment activity slows. 
• Higher interest costs strain the budgets of public entities and governments, making them slow their expenditure and investment to avoid rising debt levels and debt costs.

• Consumers feel the pinch of higher capital costs through higher credit card interest and car leasing rates, rising mortgage costs, and potentially even falling incomes, as slower growth can lead to unemployment. 
• On top of all this, everyone is affected by high inflation, which reduces governments', businesses' and consumers' ability to maintain previous investment and consumption plans.
• And finally, the so-called wealth effect, due to losses in the value of assets driven damages people's willingness or even ability to spend. 

Navigating the new world of tighter monetary policy: market outlook

The past 15 months saw one of the steepest monetary tightening cycles in four decades, with virtually every major central bank hiking interest rates (or at least, allowing yields to rise). But while lending conditions have tightened considerably from ultra-easy levels since late 2021 in the US and early 2022 in the eurozone, the lending market seems to be functioning well.  Corporate refinancing is not necessarily much more difficult now, although it has become much more expensive and will continue to be so. 

The past few quarters have reminded us that the impact of monetary policy on growth comes with a considerable time lag. Recent growth rates have been low, but positive, and the record monetary tightening has not slowed economic activity too much yet. Unfortunately, the damage to growth is likely just delayed, not avoided altogether. 

Interest rates – and financing costs – have risen sharply over time, weighted by GDP for the world's most important economies. The financing cost increase has been the sharpest since the oil crises of the 1970s. Despite the brutal rise in rates, it's encouraging that the overall lending process has not been disrupted. This gives us hope that the global financial system can withstand the rates tsunami – in spite of the occasional meltdown of smaller banks that failed to manage their asset-liability mix. Still, it would be foolish to expect that exploding funding costs will not impact the consumption and investment plans of companies and individuals, and thus growth.

Evaluating the impact: financing costs, investment plans, and consumer spending

While lending conditions have tightened quite a bit, according to bank lending surveys, it seems that the ease of arranging lending has been largely unaffected. Standards have become tighter but are not yet disruptive. However, a look at the effective cost of bank financing reveals that capital costs have skyrocketed, raising the profitability hurdle for companies and projects, and jeopardizing consumer spending that relies on external funding.

In summary, we think that the damage to growth from the recent dramatic interest rate rises will turn out to be a slow-burning drag on activity over time rather than a fast recessionary flashfire, and we expect virtually flat global growth rates for the rest of 2023.