One is the persistence of inflation and a second is the likelihood that policy rates in major western economies will settle at higher levels post this inflation period than before.
Will markets again be slow to adjust their expectations?
Inflation has peaked globally and has decelerated across most economies. Of course, price levels are still higher than before. That’s a problem, especially in many countries such as the UK where wage growth has not kept pace with inflation, whereas in previous years a key component of low inflation was low wage growth. This shortfall is not only feeding the cost-of-living squeeze, dampening growth, but is also adding to pressure for higher wage settlements.
Even though financial markets are focusing on an easing of global inflationary pressures, a challenge we have noted before is that markets and economists may be slow to adjust their expectations as to where inflation will settle eventually.
In the 1970s, when many countries, led by the UK, moved from low to high inflation, this caught policy makers off guard. It was similar in the early 90s, albeit in a very different inflation environment. Then we were moving from modest but stubborn inflation to low inflation.
I remember being one of a small group of economists who felt we were moving towards a low inflation era, but then, too, markets were slow to adjust their thinking, and anticipated that inflation would return to the levels where it had previously been. The lesson is that when the inflation environment shifts, the markets may be slow to adjust and this is relevant now in terms of expectations of where inflation will settle.
When New Zealand became the first country to adopt a 2% inflation target in 1990, after two decades of high inflation, it was a radical shift. Eventually the idea of targets became not only accepted, but more particularly 2% became the accepted norm. In the eyes of the markets this then became where inflation should settle, as the target would drive policy. Indeed, last year, former Bank of England Governor Mervyn King commented that inflation was always forecast to return to 2% for no other reason than it was the inflation target.
The potential impact of second-round effects
Over the next year it is not only expected that inflation in the UK and US will decelerate but that it may undershoot (on a year-on-year comparison) its 2% target. But then what? It would not be a surprise if inflation were to settle higher, say around 3%, perhaps even 3% to 4% rather than 1% to 2%.
That potential outcome is linked to a number of other key issues attracting attention now, such as second-round inflation effects. The challenge is that second-round effects – whether it be private sector wage increases in excess of productivity or firms boosting margins – add to pressure for central banks to keep monetary policy tight.
Equity markets, for instance, are discounting solid corporate earnings growth. Following such a large rise in costs, unless firms are seeing huge productivity gains then their ability to maintain or indeed raise profit margins will be influenced by whether they can pass on higher prices. But if this leads to higher inflation then it will add to pressure for further monetary policy tightening. In the immediate outlook, higher earnings growth would thus likely sit alongside still higher policy rates.
That leads directly into present market sentiment, especially in the US, where even though headline rates of inflation are decelerating, the message from the Federal Reserve (the Fed) is that they still have a strong bias to tighten. Last week’s release of the latest FOMC minutes noted, “substantially more evidence of progress across a broader range of prices would be required”.
While some members favoured a half point hike in January (as opposed to the 0.25% move that brought the funds rate from 4.5% to 4.75%), all agreed more tightening was needed, that it would still take “some time” for policy to work and they continued to note the “very tight” labour market.
A challenge is interpreting current economic conditions given that it takes considerable time for monetary policy to feed through. The worry for the Fed is that forward-looking indicators may suggest stubborn core inflation settling above their 2% average target. This adds to their bias to tighten. In view of the latest data, the market expects a 0.5% hike at the next meeting.
Where should policy rates settle?
As noted previously, the nature of the inflation problem in the US is different to the UK and the Continent, and the bias to keep hiking here in the UK may be less than in the US. It takes time for previous tightening to feed through and for the effects to be felt.
It is not just where inflation settles but where policy rates may settle, too. The immediate path of rates needs to factor in that previous tightening is still feeding through. One fear in the markets is that central banks tighten too fast, too soon, leading to a sharp economic slowdown.
I still take the view that policy rates should settle at a higher level at the end of this cycle, and that central banks should avoid cutting rates at the first sign of economic weakness. Cheap money in the wake of the 2008 global financial crisis has allowed the recent surge in inflation to take hold and has also fed asset price inflation, led markets to not price properly for risk and contributed to a misallocation of capital.
Central banks, pre-covid, also fed the idea that policy rates should settle marginally above inflation, with the so-called “r-star” (the steady-state interest rate above inflation) being 0.5% or less. Thinking may need to move on from this. For, if nominal GDP growth – growth plus inflation – in the UK settles around 4.5% (with growth of 1.5% and inflation of 3%, say) then policy rates of 4.5% would seem appropriate. We are still seeing markets coming to terms with the persistence of inflation and the need for policy rates to settle at a higher level post-crisis than before.
Please note, the value of your investments can go down as well as up.
