The headlines are all about Ukraine at present, but I’m more worried about inflation. Last week US inflation rose, exceeding analysts’ expectations yet again. This followed a big upward surprise in inflation in Europe, led by Germany. We get the UK numbers this week and it is fingers crossed. Inflation that is rising faster than expected is a global phenomenon, with only Japan and China immune, at least so far.
Central banks have responded, with interest rate hikes now on the cards
Central banks have responded. The BoE raised rates to 25 basis points (bps) earlier this month and only the casting vote of the Governor prevented a hike to 50 bps rise. The US Federal Reserve haven’t acted yet, but their talk has changed. Their bond buying programme will stop earlier than planned and rates will probably rise by 25 or 50 bps at the next meeting in March. As for the ECB, two of the most hawkish members, from Germany and the Netherlands, have suggested that their rates could rise this year, rather than next.
But is it enough? Bond markets are expecting more as the consumer remains resilient in the face of rising prices.
The markets have moved further and are now pricing in even more decisive action. The problem is that even this may not be enough. The impact of Covid on economies is largely over, but central banks are still maintaining policy at emergency levels.
Unemployment is at or below pre-Covid levels in most countries, while surveys suggest that the labour market is even tighter with elevated prices pressures. Much of the huge fiscal stimuli from the pandemic is sitting unspent in covid piggy banks. US retails sales are likely to have surged in January when data is released this week, a pattern that will be repeated in much of the developed world. Much of this reflects a bounce back from weak December spending – consumers were worried about shortages and bought more in November – but it also reflects healthy consumer finances and the easing of Omicron restrictions irrespective of the cost of living crisis.
Central banks like to take baby steps when they tighten policy. Raise rates, wait to see how the markets and economy react, and then do more if necessary. Unfortunately, they are so far behind the curve that my view is that bigger steps are required. No one can know for sure what the right level is for official interest rates. But with economies growing above trend and inflation high and rising, I’m convinced that interest rates near zero are way too low.
What does a best-case scenario look like?
Of course, I may be wrong about how this plays out – there is still a possibility of a soft landing, with the Fed and other central banks able to slowly tighten policy.
What might that look like? In the US, housing could slow rapidly in response to the near 100 bps rise in US mortgage rates since the start of the year. Consumers would also have to resist drawing down their Covid ‘piggy banks’. A range of prices would have to fall as supply shortages eased – an improvement in the Ukrainian crisis would help here. Wage growth would have to slow, in response to reduced hiring and increased labour supply. As favourable base effects click in, shorter term inflation expectations might then dissipate.
The Fed do have the confidence of the bond market: longer term breakeven inflation rates have been remarkably stable and consistent with the Fed’s 2% inflation target. But this is a narrow cliff path and with a high risk of falling into a deeper recession if inflation stays too high for too long.
Brace for a more hawkish central bank response and volatile markets
My best guess is that central banks will accelerate tightening. This will cause some short-term problems for risk assets and a great deal of volatility. If we did have a mild recession, I would expect inflation pressures to subside rapidly. The longer-term outlook for equites remains positive. As for bonds, they are a good hedge for political tensions like Ukraine, but they tend not to help when the problem is inflation. When the dust settles, I expect equites to be higher and bond prices lower. But it won’t be a smooth path, in this uncertain world, that’s one thing for sure.
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The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.