Continuous Disclosure: Recession is not inevitable - why we shouldn't hike rates too far

Investors are increasingly concerned about the economic environment and financial asset prices. Photo / 123rf

Stock markets have slumped into bear territory but inflation is still rising.

The only way out is to hike interest rates until we're in recession, right?

Not necessarily, says Fisher Funds senior portfolio manager David McLeish.

In the latest episode of the Continuous Disclosure podcast McLeish warns there's a risk we may inflict more economic damage than we need to with overly aggressive rate hikes.

"This certainly feels like proper bear market now," he said.

"The market for most of our investing careers has shown a lot of resilience and an ability to rebound very very quickly so the fact that share prices have been falling for the best part of six months does suggest that something different is afoot from what we've had previously."

Investors were clearly becoming concerned about the economic environment and financial asset prices, he said.

"Headline inflation looks pretty terrible right now. This is pretty much the highest level we've seen in over thirty years and so it's no surprise inflation is on the tip of everyone's tongue."

But McLeish doesn't see recession as inevitable.

David McLeish, senior portflio manager fixed interest at Fisher Funds. Photo / Supplied

"That's not to say that the chances of recession aren't high," he said. "I actually think the chances are very high right now. But I do think recession can be avoided."

For that to happen central banks need to pull back from the amount of rate hikes they are currently forecasting.

In New Zealand the OCR is forecast to rise to 3.9 per cent (from its current level at 2 per cent).

Markets have priced in the prospect that it could go as high as 4.5 per cent.

For central banks to pull back, either inflation needs to ease faster than expected or they could look through short-term inflation levels and decide they'd done enough to bring inflation down over a longer term.

Right now though they were taking a more aggressive approach that did point to recession.

"There is this view that this is the necessary medicine that we all have to take, to get inflation under control."

"We are building this narrative based on a lot of economic assumptions and conventional wisdom" he says. "That's largely predicated on the belief that inflation expectations drive inflation."

The traditional theory is that if the public's expectations for where prices are headed rise too far then that can cause actual inflation.

But that theory has been challenged by some economists.

The debate was far from settled, McLeish said, but we were raising rates at a rapid rate, and based on theory that was "disputable".

McLeish said he was concerned that if central banks raised interest rates too aggressively they might unnecessarily cause a recession and ultimately do more harm than good.

Central banks are telling us that they want to sink demand down to the level of the restrained supply but there were arguments to be made that higher rates could actually further hamper supply, he said.

"Higher interest rates actually make the funding of investment projects more expensive, the cost of capital goes up. We clearly need more investment, we need more productive capacity if we are to deal with the supply-side inflationary impulse that we're experiencing," he said.

Higher interest rates also reduce the certainty that suppliers have about the supply outlook. So, by sinking demand, they will make suppliers more uncertain about bringing supply online.

A third point was that higher interest rates may cause suppliers to pare back their inventory levels, which was part of the problem we had in 2020 and 2021.

"There are a number of factors that suggest that by lowering demand you may also not actually be fixing the inflationary problem."

Meanwhile, while there is clearly still a long way to go, there were promising signs that the global supply chain bottleneck was starting to unwind, McLeish said.

"Freight costs are falling, port congestion is now starting to reduce and orders to inventory levels have come right back down," he said.

"It's only early days, we're still along way away from normal conditions but the rate of change and the direction of that change is for an alleviation of those concerns."

Continuous Disclosure is a NZ Herald Podcast.

Continuous Disclosure is available on IHeartRadio, Spotify, Apple Podcasts, or wherever you get your podcasts. New episodes come out every second Wednesday.

You can find more New Zealand Herald podcasts at nzherald.co.nz/podcasts or on IHeartRadio.