Amidst stubbornly high inflation that still shows no signs of slowing, there is a growing risk that the US Federal Reserve is making a policy error, according to market experts.
When the US Fed intervened during the March 2020 coronavirus crash to rescue bond markets, there was a consensus amongst analysts that it was the right decision at the time.
But with interest rates still pinned to the floor and quantitative easing (QE) still underway despite persistently rising inflation, there is growing concern that the US central bank could be making a policy error.
Richard Bernstein, chief investment officer at Richard Bernstein Advisors, argued that a recession is now the only way the Fed can successfully fight inflation.
“In the 1970s the Fed tried to finesse inflation, it would tighten and then ease off. But of course, it didn’t work. It just kept coming back,” he said.
“Does this Fed have the backbone to put the economy into recession? I don’t think it does. Maybe it will surprise us, but it doesn’t look like it.”
He pointed to the fact that the US central bank is holding off its tightening until March, and that it is still buying bonds as part of QE despite the latest US consumer price inflation (CPI) figure coming in at 7%.
“This Fed probably does not have the backbone to truly fight inflation and put the economy into a recession,” Bernstein said. “If that’s true, you want to assume inflation will be higher than 2-3%. That’s what we’re assuming.”
Another problem for the Fed is that inflation is being driven by supply limits instead of excessive demand, according to strategists at the BlackRock Investment Institute
They said it fundamentally changes how investors should think about the macro environment and the market implications.
“If inflation is the noise from the economic engine, in the past it was caused by the engine revving too fast,” the strategists said. “For the foreseeable future, it is more likely to be due to the engine misfiring. Inflation will arise even if economies are not running hot.”
They warned that as the world continues to grapple with supply constraints, it will bring more macroeconomic volatility.
“There is no way around this because – unlike when inflation is driven by demand – policy cannot stabilize both inflation and growth at the same time: it has to choose between them,” they explained. “In other words, central banks have to either accept higher inflation or destroy demand to rein in inflation.”
For the past few decades, the rise of globalisation and low-cost manufacturing from China has been one of the major drivers of stubbornly low inflation. But BlackRock’s strategists warned that this could be coming to an end.
“We are already seeing a rewiring of global supply chains: companies want greater security of supply – partly in response to the supply bottlenecks we have seen during the restart and partly due to increasing rivalry between the US and China, especially in the technology space,” the team said.
“Companies are moving from a ‘just in time’ to a ‘just in case’ approach and procuring more local suppliers. We may have reached the high watermark of globalisation.”
Source: BlackRock Investment Institute
Elga Bartsch, head of macro research for the BlackRock Investment Institute, said that this new macro market regime of supply-driven inflation is something that investors haven’t seen for decades, which means there is a high risk of “confusion” in the markets.
“The fact that we are in this highly unusual market regime has been a reason for us to stress some of the risks around this new regime,” she said. “As a result, we decided back in December to dial down the overall risk in portfolios a little bit because of this potential for confusion.”
Despite the rising market volatility, Bartsch said the risk of the market overreacting to what central banks are doing is higher than central banks actually overdoing it.
“At the moment, there is a lot of market discussion about when it starts and how many times it hikes in 2022,” she said.
“While that is important from a near-term sort of market timing and trading point of view, what really matters for long-term investors and asset allocators is the cumulative amount of tightening by the Federal Reserve or other central banks – and that has been much more steady.
Peter Doherty, head of fixed income at Sanlam Investments, said that if inflation is indeed supply driven, then he warned that interest rates aren't going to fix it.
“That makes the whole picture a bit less interest-rate sensitive than it might have otherwise been,” he said. “It's almost like the wrong sort of inflation for the central banks to be dealing with.”
Global stock markets have already been rattled over the past several weeks over fears of higher inflation and interest rates, with growth stocks hurt particularly hard by the sell-off.
“We're already seen the froth coming out of the markets,” Doherty added. “Those businesses that haven't made any money in the tech world that were viewed as long-term compounders, potentially they've got some stress. They maybe might have to bring forward their positive cash flow target dates.
“Anything with no cash flow with a long duration, or a long view to becoming profitable, is obviously getting hurt.”