19 July 2022
In politics, ‘regime change’ typically signifies one governing party replacing another; in economics, the same term is used to indicate a shift in various parts of the economic or financial system. While political regime changes are easy to identify, defining a regime change in economics can be more challenging.
Take inflation, for example. The developed world was in a structural inflation regime for a significant portion of 1948-1980, with price levels rising aggressively following the Second World War, a booming US economy from the mid- the ‘60s and the oil surges of the ‘70s. Since 1980, however, we’ve been in a structural disinflation regime. Under Paul Volcker, chair of the Federal Reserve (Fed) for much of the 1980s, inflation was ultimately contained by his focus on the growth of the money supply rather than interest rates, and price levels remained low and stable until the Covid-era.
Since the third quarter of 2020, we have seen persistent upside surprises, but the shape of the next inflation regime is an open question. In our view, it entirely depends on what central banks do.
If inflation doesn’t prove self-correcting, there is a straight choice between a deep recession and a once-in-a-generation inflation regime paradigm shift. Regarding the former, central banks can tighten policy for a sustained period and bring inflation back under control, thereby causing a recession.
For context, the post-War bout of inflation in the late 1940s offers some parallels with today’s environment. There was a sudden release of pent-up demand from consumers wanting to spend, there were supply-chain disruptions as the economy pivoted from a military footing, and there were widespread commodity shocks. The Fed – which had tripled the money supply from 1939-1946 to help fund the war effort – sought to shrink its balance sheet and slow the availability of credit. The result was that inflation sharply fell back from nearly 20% to a deflationary environment, and an 11-month recession ensued from late 1948.
The second option central banks have is to take policy tight but then quickly back off, due to weakness in growth, without fully getting inflation back under control. This is likely to be more painful in the long-run, increasing the likelihood of a period of stagflation, which historically leads to weakness in risk assets as the growth backdrop weakens, but – unlike in the recessionary scenario – bonds notably underperform, with real assets providing protection from inflation.
Central banks have rightfully taken a bit of bad press in recent months. They were wrong about inflation because their own inflation models are designed to always forecast inflation returning to target, and therefore are unable to deal with shocks. Looking at inflation forecasts back in Q3 2020 for the US, Eurozone, Japan and China serve to highlight this point. They were wildly inaccurate, so much so a random number generator would have outperformed their forecasts. To be fair, private forecasts were not better.
We have also had several wide-ranging and interrelated series of economic shocks that have continued to broaden from goods into services, including the supply bottlenecks across all categories resulting from pandemic-induced cuts, and of course the war in Ukraine. This has left central banks behind the curve. But they are now acting as they need to, and financial conditions are tightening. Even when actual rates have not fully risen, the increased size of the financial sector relative to the overall economy and relatively high leverage mean, as Mary Daly of the San Francisco Fed pointed out earlier this year, “the long and variable lags [of policy] may not be as long, or variable, as typically assumed.”
This cycle of hikes is already one of the fastest in recent decades, with the Fed’s policy rate expected to approach 3.6% by the end of 2022. For now, the Fed is being very clear it does not want a shift to a higher inflation regime, and if this comes at the expense of growth and weaker asset prices then this is the price they are willing to pay.