Their rhetoric has hardened further this year to stern language about normalising rates, controlling inflation expectations, and quickening QE tapering. As consumer savings and incomes continue to be eroded by accelerating price increases, the policy makers reaction has been accelerating too. The Bank of England followed the Reserve Bank of New Zealand and increased interest rates in two consecutive meetings for the first time since its independence in 1997. The European Central Bank hinted at tightening monetary policy for the first time in over a decade, and other G10 Central Banks are contemplating similar or even more drastic steps (+50bp hikes) to tighten financial conditions, in their attempts to bring inflation back under control. Some recent official communications have at times smelled of panic. The cool calm exterior generally promoted by various governors, presidents and chairpersons has given way to confusing communications and radical shifts in messaging and policy, as they struggled to adjust their models and forecasts to inflationary pressures that simply wouldn’t go away.
This change has predictably given free rein to the market to price in a rapid normalisation of rates to far higher terminal levels in the short end, resulting in continuing flattening of curves. Some countries have even priced policy over-tightening in the next two years, and then soon needing to be reversed in the case of GB, Norway, and Canada. But generally, in G10, the forward rate outlook is a series of quick hikes this year and next, then staying constant for many years. This overall reflects a scenario where inflationary pressures continue well into 2023 and perhaps 2024, something that isn’t confirmed by current pricing in inflation-protected bond markets.
Given all the one way fear, what if the inflationary pressures are mostly transitory? Demand side economics has been driven by Omicron, failure of just-in-time supply economics, and geopolitical energy pressures combined with nuclear reactor shutdowns. The invisible hand of the market economy has been shifting in response: we read of LA ports changing old slow container processing habits to more efficient ones; Baltic Dry Index on shipping rates has reverted from an extremely elevated level; restocking of inventories has quickened, with double ordering of scarce goods rife; There is finally evidence of increased supply of silicon chips, and therefore, new cars. Surely the reaction to this would be second-hand car prices declining and influencing cpi data similarly in magnitude, but negatively this time round.
Other demand side dynamics could also come into play, with the consumer facing sharp increases in cost of living due to higher energy prices, decades-high inflation, and higher taxes. Many have accumulated savings during the pandemic. Afterall, households and corporates in the US have record amounts of cash sitting in their bank accounts. However, in nominal terms these excess savings are concentrated among the wealthy. For bottom quartiles, their ”stimmies” now mostly gone, it is time to get back to work. It is also possible that some of the “great resignations” will be drawn back into the workplace as the value of their pots in equity markets soften and the reality of an increased cost of living hits the expectation of retiring early? This extra labour participation would slow the pressure on wage rises. And in the background, western housing markets have the potential to soften, as mortgage credit availability is withdrawn by banks as balance sheet liquidity reduces with QT, increased bond net issuance and rate rises.
Externally, China and other emerging markets are only adding to the uncertainty for the 2022 outlook. Many emerging markets Central Banks have already been forced to increase interest rates aggressively. Continued tilt towards tighter monetary policy mainly in the US can significantly hurt their domestic economies that are running close to peak leverage. China appears to be trying to manage a controlled slow down to decrease leverage and avoid a housing bubble bursting. Last time they dramatically reduced leverage in the economy by cooling domestic equity markets and introduced more flexibility around the exchange rate in 2015, the Fed was forced to pause interest hikes for 12 months immediately after lifting them from 0, as the global economy was too fragile to cope with tighter USD liquidity.
We believe that uncertainty around global growth, decelerating inflation pressures and normalising consumer behaviour should allow Central Banks to be patient with tightening monetary policy over the coming years. By overtightening now, they may soon be forced to swing back from excessive hawkishness to keep their balance on the credibility tightrope.
Central banks have countered the threat to their inflation controlling reputation. They should refrain from following the overtly aggressive path of interest rates currently being priced and allow economies to stabilise, while steadily removing crisis era accommodation.
