26 Jul 2022
Philip Saunders – Co-Head of Multi-Asset Growth
After a brief flirtation with deflationary risks, investors’ top concern has reverted to inflation as supply shortages have come in the wake of the ‘V’ shaped recovery. The persistence of supply-demand mismatches has been highly unusual, and we have to go back to the post WW2 recovery to find a precedent. Market inflation sensitivity is hardly surprising given the impact of yet more financialisation within developed economies, which boosts valuations even as it underpins a system more prone to episodic volatility. We believe the most serious risk for markets is regime change; if eventually inflation expectations were to become unanchored, the low interest rate regime would arguably be challenged and central banks would be forced to tighten significantly more than current expectations, with severe consequences for financial asset prices across the board.
The official line has been that the evident price and wage pressures are “transitory”, and Fed Chair Powell used his keynote speech at this year’s Jackson Hole retreat to articulate why he believes that inflation will subside. In his view inflation is not broad based, some price surges are already abating, base effects from 2020 will wash out, wage pressures are no threat so far and longer-run inflation expectations remain anchored near to the Fed’s target level of 2%. Furthermore, many of the structural disinflationary headwinds, such as demographics and technological change, will continue to blow over the medium to longer term. The Fed retains this line even as its own median forecasts for core inflation in 2022 have nudged up from 1.8% last September to 2.3% at the most recent forecast. In other words, “transitory” may last a little longer.
The Fed will be prudent
Some have argued that the Fed no longer cares about inflation and has pivoted towards a focus on its other mandated goal: that of achieving full employment. If the economy runs hot and inflation temporarily overshoots its target, so the argument goes, today’s Fed will be a lot more relaxed than it was in past incarnations, foreswearing its post Volker tendency to pre-empt rising inflation. This is much too strong a view. For one thing, it conflates time horizons. Supply-demand mismatches while the economy is restarting cannot be extrapolated into a self-reinforcing inflationary spiral underpinned by permanently higher consumer expectations. For another, it conflates the new central bank commitment to tolerate higher inflation with a central bank that cares little about inflation.
In our view, central banks may have pivoted somewhat, but they show no signs of allowing inflation expectations to become unanchored and thus squandering their hard-won legacy of credibility. They will tolerate probably 2.5% inflation on a sustained basis, but anything more will, in our view, be met with a tightening bias. Indeed, recent Fed pronouncements about the timing and speed of the ending of the emergency measures adopted in response to the impact of COVID on markets and economies seem to have surprised in their ‘hawkishness’. Finally, while we are not expecting inflation to be quite as low as was the case in the ten years or so after the Global Financial Crisis we think that Powell is right about the strength of offsetting structural factors.
Growth dynamics remain key
All this must upset the conspiracy theorists who believe that central banks are secretly conniving in a plan to get inflation up to levels that would help to inflate away government deficits. Short of a set of circumstances that were to result in central bank independence being severely circumscribed by governments, we believe central banks’ ‘reaction function’, or their response to events, has not changed in any revolutionary way. Far from complacent central bankers marching us to the edge of an inflationary spiral, it would be more correct to say that Western economies will have ‘got away’ with the printing of money on a vast scale in order to see off two major deflationary collapses.
In the shorter term, the cycle will be determined by growth dynamics. A continuing moderation towards trend growth rates in the key economies would arguably allow excess demand and supply shortages to ease and price pressures to ebb. This is particularly true given that the bar to further increases in inflation numbers is mechanically made difficult by the steep base effects—used car prices will struggle to jump 30% for two years in a row. Furthermore, consumer and business inflation expectations, while currently elevated, are adaptive and notoriously unreliable, they tend to be a reflection of the status quo and the hyped-up news environment rather than providing leading information.
The risk to this view is a reacceleration of growth resulting from widespread herd resistance to COVID, which causes a series of rolling demand shocks that disrupt key sources of supply. This would cause inflation to remain stickier for longer, forcing central banks to raise rates faster and well above current consensus expectations. We remain in the former camp – high prices tend to be the best cure for high prices – and believe supply responses tend to be what gets underestimated, as does the impact of tightening liquidity, the effects of which are already having an impact.
Rather than rising inflation, tightening liquidity is the more likely candidate to spoil the party.
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