The world has witnessed a round of high inflation since 2021, which is more severe than most market watchers had anticipated. In response to rising inflation, central banks of developed economies have hiked interest rates one after another, having a pronounced negative effect on the global economy. China, affected by the phenomenon as well, has actively adjusted its policies to seek a way forward. As a result, both its economic growth and the external environment are now expected to improve this year.

 

Causes of inflation

 

Four factors have jointly led to high global inflation.

 

First, the COVID-19 pandemic and the Russia-Ukraine conflict dealt a big collective blow to the global economy from the supply side.

 

Second, the United States and other major countries implemented extremely accommodative fiscal and monetary policies after the pandemic, greatly raising household incomes and money supply.

 

Third, the US Federal Reserve did not take timely action to curb the resulting inflation. Before price rises began, the previous long-lasting low inflation levels had led the Fed to adjust its monetary policies, changing from "inflation targeting" to "average inflation targeting". That means if the growth of its consumer price index runs below 2 percent for a long time, the US can tolerate a period thereafter when CPI growth remains above 2 percent. In addition, most Fed policymakers regarded inflation at the time as a temporary shock that wouldn't endure for long.

 

Fourth, the trend of anti-globalization since 2016 has also added to the current situation. In one prime example, the US initiated a trade conflict and reduced its imports from China, which significantly increased overall costs because the imports from elsewhere are more expensive. In addition, there is increasing fragmentation in global supply and industrial chains, thus reducing the efficiency of resource allocation and raising production costs worldwide.

 

Interest rate hikes

 

Against such a backdrop, the world's three major central banks — the Fed, the European Central Bank and the Bank of England — have unleashed an extremely steep series of interest rate hikes and balance sheet drawdowns since March 2022 to manage inflation, which unfortunately has not yielded the desired results so far.

 

The Fed, for example, raised interest rates four times from June to November 2022, each time by 75 basis points. However, it only reduced the year-on-year growth of the core CPI, the indicator most cited by the Fed, from a peak of 6.7 percent to 4 percent in October — still well above the 2 percent target level.

 

Price swings and levels in the three major areas of goods, services and rent jointly determine the core CPI. Currently, US prices of goods have dropped a lot, the decline in service prices is less drastic and rent has largely remained unchanged, eventually leading to the slow decline of the core CPI's year-on-year growth. The latter two categories remain high mainly because the US labor market is still in short supply and employers feel strong pressure to pay more.

 

In conclusion, if the local labor market does not deteriorate significantly, it will be very difficult for the US to drop its year-on-year growth target of core CPI to 2 percent in the short term and it will be unlikely for the Fed to cut interest rates either. There is a high possibility that the global economy and financial markets will continue to operate in the context of very high short-term and long-term interest rates in the first half of this year.

 

Negative effects

 

The interest rate hikes by central banks spanning the globe have had several negative effects on the world's economy.

 

The situation has put great pressure on both local currencies and prices in developing economies.

 

From March 2022 to the first quarter of last year, financial crises of varying degrees broke out in eight developing countries with relatively fragile financial systems, including Pakistan, Argentina and Egypt.

 

In the second quarter of last year, lenders in Europe and the US began to experience severe stress as interest rates kept rising. Silicon Valley Bank, First Republic Bank and Signature Bank in the US collapsed despite the first two being medium-sized banks ranked between 10th and 20th in the country. Europe's Credit Suisse and Deutsche Bank were also deeply ensnared in similar crises.

 

In addition, in the first half of this year, long-lasting high interest rates will possibly bring additional challenges.

 

The US corporate bond market, especially the segment of high-yield corporate bonds, may find itself overwhelmed as both benchmark interest rates and the risk premiums continue to intensify, based on the fact that financing costs are already very high.

 

In addition, debt pressure faced by major economies will increase significantly. In the past, these governments had high debts, but they accumulated in a climate with low economic growth, low interest rates and low prices. As a result, there was not much pressure to get such debts under control.

 

China's economy

 

Also affected by the interest rate hikes, this year, China's trade performance may come under more pressure. External demand may continue to decline if US import restrictions remain in place.

 

However, as China has made a series of policy adjustments, there is a high possibility that this year its economic growth will be more robust and the overall external environment will be more satisfactory, with foreign direct investment increasing and short-term capital outflows declining. In addition, the renminbi's recent exchange rate against the US dollar has already largely rebounded and this uptrend is likely to continue in 2024.