Hitting the lower bound (of inflation)

After we pointed out the possibility of a “sticky” inflation scenario in a previous article last year, with inflation somewhat easing in Q3 and Q4 2023, market participants reacted aggressively, pricing in more than six rates cuts by year-end. This optimism was short-lived – inflation stubbornly persisted in the 3.5-4% range, and by February and March, the Fed’s hawkish shift reversed those expectations. Markets reverted to a “higher for longer” interest rate outlook, becoming increasingly sensitive to any economic data hinting at inflation’s future direction.

Over the last year, we’ve identified several forces that will likely sustain inflation structurally, among others:

• Decarbonization costs: The global shift towards clean energy will incur expenses.
• Climate change consequences: Insurance, reinsurance costs, and increased seasonal energy demands – driven by climate change – will affect both households and businesses at large.
• Agricultural commodity limitations: Seminal higher costs for agricultural commodities as we reach the limits of yield enhancement and cultivable land availability. Recent cocoa price hikes (due to weather affecting harvest in Ivory Coast) exemplify potential disruptions.
• Scarcity of key commodities: Certain commodities crucial for industries and new technologies, like base metals and rare metals, face potential supply-demand imbalances, as seen with the recent copper prices increase.

Beyond these structural forces, several transitory factors contribute to inflation, including recent uptick in freight rates due to ongoing risks in the Red Sea shipping route.

Lastly, while some second-round effects have already gone through the system, progressive increase and negotiation of salaries aimed at addressing long-term purchasing power losses for low decile earners could add further short-term pressure.

These observations raise a crucial question: what will central banks do if inflation hits a lower bound of 3 to 4% for a prolonged period, potentially several years?

In such a scenario, central banks face three options:

Set a new inflation target

The “natural rate” of unemployment or inflation, and the optimal level for real interest rates, have long been debated by economists and policy makers. As we’ve previously argued, the 2% target set by central banks is based on subjectivity rather than any exact rigorous theory.

There are increasingly voices who – like us – point to the risk that sticking dogmatically to a 2% inflation target poses to global economies grappling with structurally sticky inflation. Early signs suggest this approach might negatively impact household balance sheets, as seen in Canada.

Yet, we believe the probability of an explicit change to the target inflation rate by central banks in the short-term is extremely low. Doing so could further erode central bank credibility, already weakened by their post-Covid “transitory” blunder. Additionally, it could further confuse investors at a sensitive point in the interest rate cycle.

Adopt a policy of implicit flexibility

Many central bankers are aware of the above-mentioned risks. The ECB and the Bank of Canada have signaled that they are amenable to start cutting rates if they consider that inflation is sufficiently tamed and heading further down. (i.e., before reaching the 2% target).

This pragmatic approach reflects a critical balancing act: the necessity of anchoring inflation expectations, while acknowledging that the 2% target might be unrealistic in a new world, with a 3-3.5% base inflation.

As we move forward, we believe more central banks will adopt this approach and seek to provide themselves with optionality.

Stick to the rule book

So far, having changed its tone in early 2024, the Federal Reserve stands out as one of the strictest of developed markets central banks.

While the fall of 2023 was marked by some perceived dovishness, Chair Powell gear switch in the winter of 2024 triggered a dramatic reversal in market expectations.

In our view, the Fed is suffering from over communication. The sheer (record) volume of Fed speeches is creating increased uncertainty in setting expectations, which paradoxically is the exact opposite of what the Fed’s communication is supposed to achieve.

Given, Powell’s history of switching discourse in short order, a likely scenario is that at some point he would also lean towards being more flexible without explicitly changing the inflation target.

This approach carries two main risks. The longer Powell remains dogmatic and inflexible, the higher the potential risk down. Also, how he will navigate a change in tone – once again – will be key, and could trigger a rapid shift in market expectations, given their current focus and heightened sensitivity to inflation news.