Our Opinion: 2023
The Rocky Road of Inflation
Given how poorly most investment portfolios performed over the past year or so, you may not have noticed that financial markets started 2023 floating high on optimism. Investors have increasingly bet that inflation, the world economy’s biggest problem, will fall away without much fuss. The result, many think, will be cuts in interest rates towards the end of 2023, which will help the world’s major economies avoid a recession.
In anticipation of this welcome turn of events the S&P 500 index of American stocks rose by nearly 8% in the first six weeks of the year. It was not just American markets that jumped. European stocks rose even more, thanks partly to a warm winter that curbed energy prices. Money poured into emerging economies, which enjoyed the joint blessings of China abandoning its zero-covid policy and a cheaper Dollar.
This was a rosy picture, and probably misguided. Markets have since fallen back as the reality sinks in that the World’s battle with inflation is far from over.
For a sign of what got investors’ hopes up, look at America’s latest consumer-price figures, released on February 14th. They showed less inflation over the three months to January than at any time since the start of 2021. Many of the factors which first caused inflation to take off have dissipated. Global supply chains are no longer overwhelmed by surging demand for goods, nor disrupted by the pandemic. The oil price is lower today than it was before Russia invaded Ukraine a year ago. The picture of falling inflation is repeated around the world: the headline rate is falling in 25 of the 36 mainly rich countries in the OECD.
However, fluctuations in headline inflation often mask the underlying trend. Look into the details, and it is easy to see that the inflation problem is not fixed. America’s “core” prices, which exclude volatile food and energy, grew at an annualised pace of 4.6% over the past three months, and have started gently accelerating. The main source of inflation is now the services sector, which is more exposed to labour costs. In America, Britain, Canada and New Zealand wage growth is still much higher than is consistent with the 2% inflation targets of their respective central banks; pay growth is lower in the euro area but rising in important economies such as Spain.
This should not be a surprise, given the strength of labour markets. Six of the G7 group of big rich countries enjoy an unemployment rate at or close to the lowest seen this century. America’s is the lowest it has been since 1969. It is hard to see how underlying inflation can fall whilst labour markets stay so tight. They are keeping many economies on course for inflation that does not fall below 3-5% or so. That would be less scary than the experience of the past two years. But it would be a big problem for central bankers, who are judged against their targets. It would also blow a hole in the optimistic vision from investors.
Whatever happens next, market turbulence seems likely. In recent weeks bond investors have begun moving towards a prediction that central banks do not cut interest rates, but instead keep them high. It is conceivable that rates stay high without seriously denting the economy, while inflation continues to fall. If that happens, markets would be buoyed by robust economic growth. Yet persistently higher rates would inflict losses on bond investors and continuing elevated ‘risk-free’ returns would make it harder to justify stocks trading at a large multiple of their earnings.
It is far more likely, however, that high rates will hurt the economy. In the modern era, central banks have been bad at pulling off “soft landings”, in which they complete a cycle of interest-rate rises without an ensuing recession.
There is also the possibility that central banks, faced with a stubborn inflation problem, do not have the stomach to tolerate a recession. Instead, they might allow inflation to run a little above their targets. In the short run that would bring an economic sugar rush. It might also bring benefits in the longer run. Eventually, interest rates would settle higher on account of higher inflation, keeping them safely away from zero and giving central banks more monetary ammunition during the next recession. For this reason, many economists think the ideal inflation target is above 2%.
Yet managing such a regime shift without wreaking havoc would be an enormous task for central banks. They have spent the past year emphasising their commitment to their current targets, often set by lawmakers. Ditching one regime and establishing another would be a once-in-a-generation policymaking challenge. Decisiveness would be key; in the 1970s a lack of clarity about the goals of monetary policy led to wild swings in the economy, hurting the public and investors alike.
So far central bankers in the rich world are showing no signs of reversing course. But even if inflation falls or they give up fighting it, policymakers are unlikely to execute a flawless change of direction. Whether it is because rates stay high, recession strikes or policy enters a messy period of transition, investors should set themselves up for a rocky road ahead.
12th March 2023
