How the major central banks react to such a scenario of persistent inflation will have profound market implications, writes Bank of America's Athanasios Vamvakidis in an exclusive op-ed for the Delphi Forum Journal.
After 20 years of low inflation, prices are now increasing fast throughout the world economy. Headline inflation has increased to more than 8% in both the US and the Eurozone. Core inflation, which excludes volatile energy and food prices, is almost double the target of 2% in the Eurozone and triple this level in the US. Some inflation may have been welcome during the recovery from the pandemic, particularly after being below the target for so long before, but inflation so high is a threat to the global economy.
Central banks have taken a U-turn and are now tightening their policies. The Fed has stopped quantitative easing, has started shrinking its huge balance sheet and has begun hiking rates, with the market pricing a terminal rate 3% for 2023. The ECB is also about to stop quantitative easing, while Lagarde has indicated that they will bring rates back to zero, from -0.5% currently, by September; the market is pricing an ECB terminal rate of 1.5% in 2023. Most other central banks are also tightening, after very loose policies since the global financial crisis, and even more so since the pandemic.
Market volatility has increased sharply. Investors have relied for too long on central bank support, the so called policy put. Bad news, such as weak economic data, used to be good news, because of market expectations that central bank will ease policies even more. As a result, every new shock was leading to a new high in risk assets, after an initial, temporary dip. As central banks now have to focus on inflation, markets have lost a key support. High interest rates also mean lower valuations. The drop in real incomes means lower demand and lower profitability. As global yields and spreads have increased, global equities have dropped by more than 15% since their peak in November, with technology stocks suffering the most. In the Eurozone, periphery spreads have increased sharply, bringing back concerns about fragmentation.
The adjustment has only just started. Markets are still pricing a benign scenario, in which inflation drops back to the 2% target almost everywhere in the next two years, without a substantial increase in unemployment and with a mild monetary policy tightening. This is an ideal soft landing scenario but not the most likely. With inflation the highest and unemployment the lowest in recent decades, in the US, the Eurozone, the UK and in most of the rest of the word, unemployment will have to increase for inflation to decline. Simple monetary policy rules, such as the Taylor rule, would point to the need for much higher interest rates in most countries.
The risk is that inflation will be sticky on the way down and will settle at well above the 2% target. Assuming energy prices stabilize and supply bottlenecks from the pandemic are resolved, we should see lower inflation in the months ahead. However, it is more likely to stabilize at 3% or even 4%, as opposed to 2%, which markets expect. This is more of a risk in the US, but also in the Eurozone. Globalization, which kept prices low in the previous 2-3 decades, is now reversing. The recovery from the pandemic has been V-shaped, with massive fiscal stimulus supporting demand and leading to overheating in some cases, in contrast to the balance sheet recession and the massive deleveraging that followed the decade after the global financial crisis. What led to low inflation in the previous decades is not in force anymore, suggesting we have entered a new era of higher inflation.
How the major central banks react to such a scenario of persistent inflation will have profound market implications. If the Fed sticks to its 2% target and keeps hiking, equities will suffer and the US Dollar will strengthen from an already strong level. If the Fed is complacent, risk assets will initially rally, although this is unlikely to be sustainable, and the US Dollar could weaken sharply. For the ECB, the dilemma will be between sticking to the 2% inflation target and supporting the periphery, where higher rates and a strong Euro could bring back market concerns about debt sustainability. Central banks will face very difficult dilemmas in the years ahead.
Global Head G10 FX Strategy
Bank of America