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Interest rates around the world are rising at an alarming pace, as central banks admit that inflation is becoming more ingrained rather than just a series of transient shocks. For many, this feels like the dawn of a new regime in monetary policy and financial markets.

At its meeting in July, the US Federal Open Market Committee (FOMC) raised the federal funds rate by 75 basis points (bps) to take the range to 2.25%–2.50%. This means that the most important interest rate for the global economy has risen five-fold in the space of just three months. This has negatively impacted both government bonds worldwide (with yields rising and prices falling), and also risk assets, such as share prices.

In Europe, the European Central Bank (ECB) raised all of its main interest rates by 50 bps, ending eight years of negative interest rates. Even the UK’s Bank of England (BoE) surprised the market by raising rates by more than the market had expected.

The era of zero or even negative interest rates is over. A definitive regime shift has occurred, taking us into a new era. That said, more seasoned investors may see this as a return to more normal times, akin to the period before the global financial crisis in 2008. However, that is yet to be seen. It could be that the stagflation (a period of persistently high inflation combined with high unemployment and stagnant demand) experienced in the late 1970s and early 1980s may be the more appropriate comparison.

Recessions expected in the next year

The new interest rate regime means that we now expect the US, UK and eurozone economies to go into recession (defined as two successive quarters of declining economic output) over the next year. All three of these markets will experience significant declines in output over the course of the following year, and the outlook for the global economy is grim.

Inflation is now one of the biggest concerns for households when considering their own financial situations. Politicians are discovering that they are not immune from blame, as voters, who have become used to government help during difficult periods in recent years, now expect government support again. With central banks seeking to tame high inflation, monetary policy is constrained, leaving governments to ease the pain of higher inflation where possible.

In the UK, rising inflation has been dubbed the “cost of living crisis”, as home energy bills are set to triple in as little as a two-year period. Europe is facing an even more acute crisis, with energy supplies from Russia being threatened against the background of the war in Ukraine. Governments across the region are scrambling to find ways to help households, especially those on low incomes.

Global economy facing worst year since 2009

We have downgraded global economic growth markedly in the new Schroders baseline forecast, with recessions now predicted for the US, the eurozone and UK, while most emerging markets will also see slower growth. Global growth is now expected to slow from 5.9% to 2.6% this year (revised down from 2.7%) and slow to 1.5% in 2023 (previously 2.7%). Apart from during the height of the Covid-19 pandemic, this would be the worst year for the global economy since 2009.

We have downgraded US economic growth from 2.6% in May to 1.7% for 2022, significantly lower than market estimates of 2.1% growth. This is mostly driven by our higher inflation forecast (8% for the year vs. 6.9% previously) and a more aggressive path for the fed funds rate.

Our forecast has the US Federal Reserve (Fed) tempering the pace of hikes, but for rates to reach 4% by the start of 2023, compared to market expectations of 3.65%. Higher interest rates, less generous government spending and higher inflation all work to reduce the spending power of households, which are expected to eventually cut spending meaningfully. Companies are likely to respond to weaker demand by slowing production and as such, also reducing demand for labour. Policy tightening is expected to be severe enough to drive the unemployment rate higher, which is required to see not only household demand fall but also inflation pressures ease.

Spiralling energy costs will cause dip in European output

We expect the US economy to slip into recession over the first three quarters of 2023, with economic output set to contract by 1.9%, before returning to growth. To highlight how negative this forecast is, the fall in output means the country’s economy contracts by 1.1% for all of 2023, compared to consensus estimates of positive growth of 1%.

Unlike the US, Europe’s recession will not be caused by domestically generated inflation and rising interest rates. Instead, spiralling energy costs related to the war in Ukraine are now severe enough to cause a dip in output.

Compared to the US and eurozone, the UK seems to sit between the two. Economic growth has been more resilient of late, and there is more evidence of inflation pressures broadening. However, the UK is also forced to endure high European energy prices, which will hit households with a lag due to the government’s energy price cap.