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A Looming battle: Increasing interest rates vs OPEC production cuts

Large parts of the world economy are due to enter recessionary territory in the fourth quarter of 2022. Uncertainty, however, remains on how long this recession will last. Much of the uncertainty stems from a new threat, namely OPEC+’s inclination to cut oil production - to drive up oil prices, which may force central banks to keep interest higher for longer. However, the event which roiled financial markets was an “extraordinary energy package” in the UK – which forced the government to reverse course.

In the US the economy contracted by 0.6% in Q2 2022, following a contraction in Q1 2022. Weakness is due to continue, not least due to another 75-basis point increase in interest rates. The Federal Reserve has since March 2022 increased the Federal Funds rate by 300 basis point to 3% - 3.25%. However, the Fed is still regarded as “behind the curve”, meaning monetary policy is still accommodative and stimulatory, given consumer price inflation of 8.3% in August and a low unemployment rate of 3.7%. Current indications from the Taylor rule suggest the terminal rate may be 5.5%, but it may even be higher. And there is a lot of uncertainty on just when a terminal rate will be reached, and how data dependent and patient the will be with high inflation.

However, as central bankers around the world raise interest rates to slow demand in an attempt to reduce the pace at which inflation increases, OPEC+ (OPEC and non-OPEC oil producers, including Russia), is set to continue with production cuts. Depending on the size of production cuts, the price of oil may well rocket back to above $100 per barrel – and renew pressure on inflation to increase, which may force central banks to raise interest rates to real high levels and keep it there for a prolonged period, which may force OPEC to cut production again. And so the cycle may continue until a compromise is reached.

Should this cycle continue for a prolonged period, social

may take on violent forms. Indeed, the Civil Unrest Index showed 101 countries witnessed an increase in civil unrest in Q3 2022. This is bound to impact political stability as citizens protest against increases in the cost of living, high electricity and fuel prices and the shortage of energy products.

The UK’ energy support package attempts upport package attempts to alleviate the cost-of-living crisis caused by the energy shortages. The plan, among others, aims to cap annual energy bills at £2 500. This means it can rise from the current £1 971 to £2 500, but it will be lower than the expected peak of more than £6 000 next year. Inflation may thus peak at 11% in Q4 2022 instead of the anticipated 16% in Q2 2023. Furthermore, the government proposed to cut the 45% personal income tax bracket to 40%, which caused an uproar as the “poor” will subsidise the ”rich”. This proposal was withdrawn following the outcry. However, financial markets did not react well to the proposals. Investors worried that a fiscal expansion will cause inflationary pressure, while the central bank attempted to reduce it. The concern is also that increased government borrowing to fund the package will tighten credit market conditions. Consequently, British bond yields surged, while British share prices fell. At 3.77% the 10-year bond yield hit the highest level since 2011 (1.85% in July), while the pound depreciated to US$1.11, the lowest since 1985.

In South Africa load shedding continued unabated as some power stations were sabotaged, while others failed. In the meantime, the Reserve Bank raised the repo rate by another 75 basis points as inflation seem to have peaked – for now. Another rate increase of at least 50 basis points is expected in November. The rate increase, however, was not enough to stem the rand’s depreciation, as the international markets are now in full “risk-off” mode, ridding themselves of “risky” assets. This will continue until clarity is gained as to when the world may end and when interest rates may start on a declining trend.

Multivest Economic Division

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