Scottish mountaineer William Hutchison Murray famously advocated that “until one is committed, there is hesitancy, the chance to draw back, always ineffectiveness”. It is estimated the average person makes 35,000 decisions a day. While most are made quickly, bigger ones merit more contemplation.
While not climbing literal mountains, central bankers face a major decision that will likely set the tone for economies and markets in 2022. While inflation in the developed world has risen uncomfortably, lockdowns and restrictions remain firmly part of the pandemic response – causing supply disruption.
Should central banks raise interest rates to deal with inflation levels, or should they look at the bigger picture and recognise the one-off nature of today’s price dislocations? The stakes are higher than usual, with asset prices across capital markets elevated based on assumptions around persistent low interest rates. If those assumptions are proven wrong, so too will be prices of equities, bonds, real estate, and almost all investable assets.
Today’s inflation surge has triggered alarm, in part because it is so long since price rises have been a problem. The last major inflationary era was during the 1970s and 1980s energy crisis.
Economists and central bankers are not used to dealing with inflation, though they accept runaway prices have historically hurt economies, for example in Weimar Germany and Zimbabwe. As such, many central banks now have an explicit mandate to deal with inflation but policymakers have barely used it.
The US Federal Reserve’s website states “inflation of 2% over the longer run is most consistent with the Fed’s mandate for maximum employment and price stability”. For many inflation ‘hawks’, it is bad enough that the Fed’s preferred inflation indicator, Core PCE, has breached this 2% threshold by a large margin.
Some of the causes of inflation may persist. Supply chain disruption has contributed to higher prices, partly due to ‘zero-Covid’ policies in Asia. In China, mere symptoms result in automatic hospitalisation, while state media express ‘astonishment’ at the idea of easing restrictions.
The Chinese government has set too much store in its pandemic response to reverse course. Spot lockdowns of entire factory towns, with the disruption they cause to supply chains relying on their output, look set to continue.
Perhaps with these disruptions in mind, Fed Chair Jerome Powell declared at the end of November that US inflationary pressures were too high, and it was appropriate to consider ending the bond-buying programme that kept longer-term interest rates artificially low to support growth.
Call to action? US core inflation sits well above the Fed’s 2% mandate
Source: GAM
The case for not aggressively raising interest rates may be even stronger. Short and long-term growth prospects remain challenging. Consumers across developed markets are cautious, with confidence knocked yet again by the Omicron variant and restrictions tightening in response. This harms the travel, leisure and hospitality industries.
In the US, labour market dislocation accompanied by wage rises have been inflationary. This may soon reverse. In spring 2020, 22 million US jobs were lost but are now close to all being added back.
December’s jobs data showed workers’ average hourly earnings eased off, though at a still relatively high near 5% annual gain. A few more months of job additions will likely see wage gains ease off outright as labour availability picks up, removing inflationary pressures.
Recent history offers an insight into the likely course of inflation. A survey of recent post-recession prices and related delivery times by the US Institute for Supply Management reveals heightened inflation is to be expected after a crisis and has consistently fallen away afterwards.
Finally, pandemic aside, strong economic growth and associated price rises seem unlikely amid long-term ‘secular stagnation’ driven by climate change, unfavourable demographics, and inequality. The pandemic has done little to fix these. The Piketty Lab, which monitors world inequality, recently said the crisis ushered in a ‘Golden Age’ of billionaire wealth with severe growth consequences.
Been here before: inflation’s post-recession record is illuminating
Source: GAM
It must be asked how significantly higher interest rates could help. Higher rates will not resolve a lack of truck drivers to pick up containers delivered to US West Coast ports. Nor are they likely to help amid the ongoing pandemic response.
What they will do is dampen economic activity and upset markets. Central bankers might be ‘victorious’ in the narrow sense of beating demand down to the level of constrained supply, thus ensuring adherence to inflation targets. But monetary policy operates on a lag, and rate rises will take months to trickle through. By which time, some causes of inflation may have resolved themselves.
This is ‘The Great Test’. Will central banks resist the siren call to unnecessary action? If they do, investors can continue to navigate a realistic long-term scenario of low growth and low rates via long-duration assets.
If, however, central bankers act now to aggressively deal with inflation, then in our view investors’ focus will need to shift towards capital preservation until the error is reversed. Interest rate-setting committees are not mountaineers. They should be revered as much for deciding when to do nothing as for acting.
Julian Howard is lead investment director of multi-asset solutions at GAM Investments. The views expressed above are his own and should not be taken as investment advice.