Sticky, Broad Based Inflation
But that was in a different inflationary environment – CPI during this period was at or below 2% – now is different. As early as September last year there were rumblings that Covid driven inflation may not be as transitory as hoped – prices were being driven higher by both supply and demand side factors. In early December, the term “transitory” was officially retired by both Chairman Powell and Treasury Sec. Yellen, and yet the printing presses kept rolling. So, despite growth bouncing back, unemployment at 3.9% (near historic lows) and inflation (now accepted as broad based and sticky) at 7%, the Fed continued to print money and keep rates at historic lows for a further quarter – adding some $300bio to their balance sheet.
The Fed weren’t alone, the reaction functions of the BoE and ECB were also slow, and this policy error has helped put us in the position we are now. Inflation is increasingly broad based and printing multi decade highs across the developed world. In the US, recent numbers have shown worrying increases in rent and food prices and in the UK, we have inflation at 40y highs being driven by everything from fuel to furniture. On the back of recent numbers, rhetoric from the banks is starting to shift and become even more aggressively hawkish. Powell has suggested the Fed “won’t hesitate” to take rates beyond neutral if needed, and ECB member Knot hinted that moves of 50bps are in play, a marked escalation from a bank which has moved in 10bps increments since 2014.
The scenario all central banks would love to engineer from here is an economy with marginally higher interest rates, bringing inflation under control but avoiding a hard landing – unfortunately, their hesitation has made this outcome increasingly unlikely. For risk managers and investors alike, the risks seem clear – inflation, now embedded, refuses to retreat in the face of ever-increasing rates. The market pricing of “neutral” rates is off the mark – inflationary pressures from deglobalisation and supply issues, worsened by resurgent East/West tensions, means that we are back in a higher rate environment where “normal” is again 4-5%, not the 0-1% we have seen for the last decade.
Whether the above plays out and rates persist at elevated levels for an extended period or not, if inflation remains sticky, central banks will have to move faster and perhaps wean markets off their meticulous forward guidance. Recency bias is hard to overcome, and it is tempting to assume rates won’t move too much higher from here, but this needn’t be the case. If your business or investment works with rates where they are today, there’s an increasingly compelling argument to take rates risk, and the incoming volatility, off the table as we march toward a period of economic fragility.