What risks do the economy and markets face from higher interest rates?

Both the Fed and the ECB have confirmed that they are not done fighting inflation and that they will continue to raise rates at upcoming meetings. The Fed's latest dot plot showed a peak rate of 5.1% in 2023, which seems a reasonable base case. For its part, the ECB suggested that it might raise its deposit rate above 3%.

However, central banks do not really know where they need to go to bring inflation back to target. Ultimately, data showing how economies react to ongoing tightening will dictate the pace and extent of tightening in the future.

Risks to the economy and markets

The risk of central banks overreaching is pronounced, given that recent monetary policy tightening has occurred at a rapid pace and it will take some time (up to 18 months) to see its full impact on the real economy. Moreover, in the euro area, although the energy crisis has so far turned out to be mild, energy prices are likely to remain high over the next year, which will weigh on growth. The ECB's current economic forecasts appear overly optimistic.

Markets are struggling to adjust to a new environment of higher interest rates. As the LDI fund crisis in the UK demonstrated, there are unknown pockets of the market that are particularly vulnerable in the current environment and the risk of a crash is high.

While central banks are determined to fight inflation, a market crash involving systemic risk would force a rethink of policy settings.