Bank Woes Shift Sentiment
31 March 2023
The Banking Crisis: Too Soon to Celebrate
12 April 2023INSIGHT • 5 APRIL 2023
Beware of ‘common wisdom’
Kambiz Kazemi, Chief Investment Officer
The markets weathered many storms throughout March, including the SVB deposits flight, the last minute government-orchestrated takeover of Credit Suisse and uncertainties in the run up to the Fed’s meeting on March 22nd.
But they breathed a sigh of relief with the March 31st release of the Fed’s favorite measure of inflation, the PCE Core Deflator, coming in close to expectations at 4.6% YOY. The figure was welcomed with inflation continuing to soften, albeit moderately. However, it is hardly reassuring as it remains widely above the Fed’s self-defined long-term inflation target.
At this stage, most investors and analysts appear to foresee one of two main scenarios: a) growth versus inflation, or b) persistent inflation.
Scenario A: Growth vs. inflation
The Fed and other central banks’ recent hiking policies have borne fruit by slowing down growth, either acutely (i.e., hard landing) or progressively. As a result of lower growth and—as ‘common wisdom’ has it—lower demand, price pressures will reduce and help dissipate inflation concerns. This will potentially result in lower short-term rates.
In reality, market expectations for the Federal Fund rates project a peak rate of 5% in June 2023 followed by cuts as early as September.
Meanwhile, one-year expectation of inflation as measured by inflation-linked bonds sits at 3.2% while the University of Michigan Inflation Expectation (1 year), which surveys households, was at 4.1% at the end February 2023 – more in line with the Fed’s 4.2% projection for the year ahead.
This divergence between market expectations and the Fed will need to narrow and converge over the coming year. It is worth nothing that this process will continue to sustain volatility in short-term rates as market expectations and/or the Fed’s tone shifts.
Scenario B: Persistent inflation
The main risk ahead (i.e., non-consensus scenario) highlighted by many savvy investors is that of sustained inflation and/or surprise higher inflation.
While not a core scenario, the relative strength of the labor market despite significant rate hikes has left many economists puzzled. Additionally, widespread demands for wage negotiation—particularly in Europe—and the potential for wage pressures to drive secondary inflation effects remain palpable.
This is what central banks dread the most. In this scenario, they will likely hold rates higher for longer or consider raising them further. This could have unforeseen ramifications and result in risks unaccounted for by the market. Unintended consequences could be similar to those seen during the SVB episode (e.g., higher rates could test the weak spots in the system, taking many by surprise).
Any secondary inflationary pressures will likely have unexpected consequences, which is why central banks will want to avoid this scenario at all costs. They will do so by signaling higher for longer and reestablishing their credibility.
But what if there was a third scenario? We too often rely on our recent collective experiences—i.e., our ‘common wisdom’—to project or imagine potential paths ahead. When it comes to risk management, however, it is important to test the boundaries of our imagination.
Scenario C: A new “benchmark” inflation
It is important to remember that the 2% inflation target sought by most central banks is a self-defined benchmark barely a few decades old. This approach followed the inflation trauma of the 1970s and results from regulators’ holistic and qualitative thoughts. Have the underlying forces driving inflation changed fundamentally in the subsequent decades, resulting in a higher level of ‘natural’ inflation at 3-4%?
According to ‘common wisdom’, bringing the economy to a standstill will lead to a drop in inflation. This view is largely based on policy driven by the Fed’s Chair Paul Adolph Volker in the early 1980s. It is possible to argue, however, that there are new inherent forces sustaining inflation for a prolonged period. This includes:
- A progressive increase in salaries to address the multi-decade loss of purchasing power for lower decile earner
- Costs associated with decarbonizing global and national economies;
- Seminal higher costs for agricultural commodities as we reach the limits of yield enhancement and cultivable land availability.
In this scenario, keeping rates higher to fight inflation and reach a dogmatic 2% target will only slow growth. Indeed, the relationship between inflation and growth is not written in stone. Similarly, the idea that low growth will deliver lower inflation does not always hold. One can simply look at some emerging markets where inflation and dismal growth can live alongside each other to see that our common wisdom is not universal.
This third scenario, which could appear in Q3 or Q4, would likely translate into sustained higher short-term rates with other risk assets like equities suffering as the economy slows down. In time, central bankers would realize that ‘common wisdom’ might have changed and would adopt new policies.
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