Transitioning away from ‘transitory’ inflation

In recent testimony before the US Senate, the Federal Reserve chair Jay Powell said he no longer viewed inflation as “transitory” and signalled openness to accelerating the pace of the central bank’s unwinding of the crisis-era monetary policy.

At the start of 2021, most Americans expected US inflation to stay roughly where it had been in the previous decade. Instead, inflation in the US and many other economies soared to historical highs. As we continue to look forward into 2022, market performance will likely be driven by how policymakers will respond to the ongoing health crisis and inflation.

The emergence of the Omicron variant has brought a twist to the health crisis. The World Health Organization labelled it a “variant of concern”. This new strain will likely force the developed world’s central banks to continue to be cautious. This may result in inflation remaining high, with fiscal and monetary policies being kept loose. In such an environment, bonds would likely prove to be very poor investments. Value stocks would probably outperform growth stocks and emerging markets would likely outperform US equities as most emerging market fiscal and monetary policies are already being tightened.

Ray Dalio, the founder of the world’s biggest hedge fund firm, Bridgewater Associates, recently said, “Cash is not a safe investment, is not a safe place because it will be taxed by inflation”.

Dalio explained how the stock market rebounded swiftly from the pandemic bottom in March 2020, thanks to the massive fiscal and monetary stimulus measures governments and central banks orchestrated to support their economies. However, these measures created certain economic and political problems, chief among them inflation. Investors should be critical on assessing the likely global macroeconomic environment in 2022 and how it will impact the investment environment, especially financial markets, as investors make strategic asset allocation decisions.

A closer look at how some of the large economies have been responding to the ongoing health crisis and mainly to inflation in 2021 through fiscal and monetary policies should provide a good preamble to consider the likely changes in the global macroeconomic environment this year.

Canada

The Bank of Canada is at the forefront among the G7 central banks in slowing its stimulus efforts. In October 2021, it ended its bond-buying stimulus programme and accelerated the potential timing of future rate increases amid worries that supply disruptions were driving up inflation. The bank indicated that high inflation rates will continue through the first half of 2022 year but should, by the second half of the year, fall back to their comfort zone of between 1% and 3%.

BOC officials still maintain that inflationary pressures are temporary, and noted recent job gains as having been broad-based with the employment rate returning to pre-pandemic levels. Analysts are now pricing in at least three rate hikes this year starting mid-2022.

European Union

The European Central Bank temporarily boosted regular monthly bond buying for half a year to smooth the exit from pandemic stimulus as forecasts show a strong economic rebound along with an outlook for faster inflation. In a statement that acknowledged the developing threat of the Omicron variant, the ECB pledged to briefly double asset purchases to cushion the end of its €1.85 trillion (US$2.1 trillion) emergency programme in March and avoid what ECB president Christine Lagarde called “a brutal transition.”

The decision is an acknowledgment that emergency policy settings must come to an end in the face of the euro area’s fastest inflation since the single currency was created and as economic output nears pre-crisis levels. It also accounts for heightened uncertainty triggered by the resurgent pandemic, which has halted economic growth in Germany.

The ECB is taking concerns about rising inflation seriously but has argued that the drivers of these pricing pressures are likely to fade over the medium term, which is the horizon that matters for monetary policy.

Lagarde explained that because inflation stemmed from supply-side issues and a surge in energy prices, it would probably slow the pace of the recovery in the near term. The ECB sees inflation in 2022 at 3.2% before sliding to 1.8% below its target; the bank remains clear that they do not expect any rate hikes in 2022.

United States of America

In the final meeting of 2021, the Fed confirmed a hawkish policy pivot, announcing a doubling of the pace of the taper to $30 billion per month, setting asset purchases on course to end by March. The Fed feels comfortable taking a more hawkish tone because inflation is currently at a nearly four-decade high and the unemployment rate has declined to near pre-pandemic levels, with businesses fervently looking for workers.

US inflation rose 6.8% in November 2021 from the same month a year before, the fastest pace since 1982 and the sixth straight month in which inflation topped 5%. All this occurred despite months and months of protestations from Fed officials, as well as Treasury Secretary Janet Yellen, that inflation would be “transitory.”

However, the Fed chair recently admitted it was time to retire this polarising term given that prices have remained higher for longer than he expected. The Fed statement effectively checked off the inflation side of the lift off test in the forward guidance, such that now the timing of lift off depends only on labour market conditions.

Employers have added workers more rapidly than Fed officials believed they would, thanks to the robust economic recovery. According to the Fed chair, Americans are becoming more accustomed to new COVID variants and that even though the Omicron variant is a risk to economic growth, it does not impact the central bank plans to accelerate its tapering of pandemic-era aid.

Policymakers now project three 25 basis points rate hikes this year, followed by three and two additional 25 basis points hikes in 2023 and 2024, respectively. The statement from the Fed provided more clarity and comfort that the Fed is not going to take anything too far and that it’s going to adjust policy as needed with a focus on inflation.

United Kingdom

The Bank of England become the first major central bank to hike its benchmark since the pandemic started; the BOE raised borrowing costs by 15 basis points to 0.25%. No other G7 central bank has made such a move since the beginning of the crisis. Officials now see an outlook for a ‘more persistent’ inflation, a shift in tone for the UK central bank, which previously said most pressures on prices were temporary, or “transitory,” and likely to pass in the next few months.

The BOE was not swayed by the emergence of the Omicron variant and the sharp rise in daily cases, which is threatening to push the country back into lockdown, as they focussed on their unemployment and inflation mandate. Officials indicated that they are seeing evidence of a very tight labour market and more persistent inflation pressures, which is what they have to act on. Expectations are now that the consumer price index will top 6% in the coming months, triple the BOE’s target. This expectation, along with the rate hike in December, now leaves room for more than two rate hikes in 2022, according to analysts.

China

To stimulate its economic activity, the People’s Bank of China recently cut the amount of cash held by most banks in reserves, a move that puts the central bank on a different policy path than many of its peers. However, the PBOC’s decision to cut the bank’s reserve requirement ratio by 50 basis points is unlikely to be a game changer for the Chinese economy. The more important drivers of China’s business cycle and financial markets are credit growth and investment. Both these variables impact economic conditions with a lag and have yet to recover decisively.

China has pursued a zero tolerance to COVID-19 and has implemented strict lockdowns and travel restrictions. Growth has been slowing against the backdrop of the common prosperity policies aimed at narrowing the widening wealth gap. China’s tighter curbs on the property market have led to a slump in construction and worsened a liquidity crisis at real-estate firms including the embattled China Evergrande Group. The PBOC decision was closely followed by a statement from top leaders pledging to stabilise the economy in 2022.

Conclusion

While the pressure on prices is evident in most developed economies, the threat of a new, more serious, variant of the virus may cause central banks to postpone plans to raise interest rates until a clearer picture emerges. This will further complicate the already complex challenges facing policy makers. For financial markets, the macro environment matters to the extent that fiscal or monetary policies are impacted. As we saw in 2021, although inflation accelerated, the policy-setting in most OECD countries stayed the same; fiscal policies remained stimulative and were funded by extremely expansionary monetary policies. Markets were able to brush off any changes in the broader macro environment. Investors should carefully consider that as policy makers begin transitioning away from “transitory” inflation, 2022 may deliver different policy responses.

Sources: Capital Economics, CNBC & Bloomberg

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.