Unchartered territory

• Persistent inflation and resilient economies suggest that monetary policy needs to be tightened more, but recent financial turbulence is a reminder that there can also be a high cost of tightening too much.

• We expect a period of stagnation or modest growth, where inflation will gradually decline, but this is a forecast with very large uncertainties in both directions – we are in a situation where history is not much of a guide.

• Unemployment has only increased a little or not at all. Wage growth is picking up, making it more difficult to get core inflation down.

Economic events over the last three years have been extreme. The Covid-19 crisis, the policy reaction to it, unexpected double-digit inflation, very rapid interest rate increases from negative or zero levels – these are not things that happen often. On top of that, we have a major war in Europe and a tense and unpredictable geopolitical situation. This is not only a difficult time for decision makers in households, businesses and investment management, it is also extremely challenging for central banks and politicians trying to avoid the most negative outcomes.

So far this year, we have gone from markets expecting a fairly rapid decline in inflation and interest rates, to fears that inflation would prove very sticky and interest rates have to be increased a lot more – and back again after problems were exposed in the banking sector. Some of the financial market fluctuations may seem excessive, but the uncertainty is real. We do not know how much monetary policy tightening is enough to stabilise inflation around 2%.

Here in the Nordic countries, like elsewhere in Europe and in the US, the economies have been remarkably resilient against the undermining of purchasing power and higher interest rates. In particular, unemployment has barely budged despite all the headwinds facing businesses. Lower energy prices have driven inflation down, but excluding that, inflation is not really decreasing yet – in some cases, like Sweden, quite the opposite. Across countries, we have increased our forecast for how high central banks will want to set policy rates to create enough of a slowdown to control the situation.

However, there was always also the risk that the slowdown would instead be a deeper crisis. Monetary policy affects the economy with delays and in magnitudes that are difficult to estimate even at the best of times, and unemployment and other economic variables can deteriorate rapidly and suddenly as history has often shown. One way this can happen is through a financial crisis. Higher interest rates are supposed to make it more expensive and difficult to borrow, but that process can spin out of control if the tighter financial conditions cause or expose problems in banks that lead to a wider loss of confidence.

The recent cases of bank problems are related to specific issues in those banks and probably do not foreshadow any wider crisis, especially given the measures that authorities have taken to reign in the problems. However, it is no coincidence that these problems appear now, where monetary tightening is really starting to be felt. For central banks, they are likely to tip the scales a bit in the direction of raising rates less, but only in a sense where they make an already complicated situation even more difficult. It remains very important to fight inflation and prevent inflation expectations from drifting too far.

Our main scenario for the US and Europe is that we face a prolonged period of modest growth where inflation will decrease. The US is a little ahead in the process and could reach 2% cores inflation in a year or so, while it will likely take longer in the euro area and countries like Denmark, where wage growth is set to be elevated for a period. Broadly speaking, this scenario would be a success for central banks, given the starting point we have now, although it would be painful for some businesses and individuals. We recognise that it will require some luck to achieve this outcome, though. Risks of both a deeper crisis and insufficient cooling, laying the ground for problems later, are large.

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