Over the past few months, we had been expecting the major economies to head into a recession. We also expected that the impact of shocks to the global economy, including supply chain disruptions and Russia’s invasion of Ukraine, would begin to dissipate. Consequently, we expected inflationary pressures to begin receding.
Our expectations for a recession have been well placed. US economic data confirms a lack of growth this year, while earnings guidance by companies does not leave room for many positive scenarios. European data is equally unfavourable. Policy makers are facing difficult dilemmas in all policy areas: monetary, fiscal, structural and international trade.
The most acute dilemma is monetary policy. High rates of inflation argue for tight monetary policy. But tight monetary policy is ineffective if inflation is driven by supply disruptions. It has been exceptionally difficult to diagnose the precise causes of the current bout of inflation. There are good arguments that at least part of the rise in the CPI is the simple arithmetic result of a rise in the price of certain goods and services due to post-Covid supply disruptions and the war in Ukraine. If most of the inflation is due to these factors, higher rates will do nothing to smooth the functioning of global supply chains or bring new natural gas supplies to Europe. All that higher rates will achieve is to engineer a needless and avoidable recession, while creating new problems in the future.
But there are also many good reasons to believe that the current bout of inflation is driven by something more worrisome: a monetary policy that has been too loose for too long, and economies that are above capacity. In this instance, higher rates are necessary to reduce economic growth. A recession would be a price worth paying to avoid inflationary expectations getting entrenched. That’s because an entrenched inflation will necessitate an even bigger recession in the future.
The problem is that there is no way of telling the extent that to which current inflation can be explained by either factor. It’s highly unlikely that reality will fit neatly within one explanation. And there simply isn’t enough data to find out. At some point in the next 2 or 3 years, I’m sure there will be excellent academic studies that will produce compelling results. In the meantime, central banks will simply need to make and fine-tune decisions as data unfolds.
Central banks have often erred. What makes the current juncture particularly difficult, however, is that never in monetary history has the starting point of the monetary cycle been as extreme. Interest rates had never been as low for as long. Negative nominal interest rates were unprecedented. Central Bank balance sheets have never been as large.
We have already seen the considerable dislocations in bond markets as a result of modest tightening. Does that imply the bond market downside remains as high? Because government and private sector debt levels are higher today than they were in the last full tightening cycle, the impact of higher interest rates is broader. Therefore, rates do not need to rise as high as previous cycles for an impact on the real economy is felt.
Against this background, fiscal policy dilemmas are also acute. Inflation squeezes household purchasing power. Demand for government support in dealing with a higher cost of living - especially in relation to energy costs – is near universal. Voters are demanding higher spending precisely at the time that fiscal authorities need to support monetary authorities by restraining spending – and hence demand – to temper inflationary pressures.
Facing tough dilemmas on both monetary and fiscal front, how can governments tackle these challenges? The viable solutions are structural by enhancing economic efficiencies. But here again governments are faced with the difficult choice of enacting policies – such as deregulation – which create dislocations at a time when growth is decelerating rapidly. It is not obvious that governments will have the political will or ability to implement such measures. Voter support is lacking for anything beyond increased spending.
Looking around the world, it is not clear that governments are making the right choices. The UK is the most extreme example. Faced with high energy costs, the government chose to assume the fiscal risk by freezing household energy bills. Rather than focussing on structural reforms that can accelerate growth and mobile investment, they chose to deliver the reward of higher growth – in the form of lower tax rates – before articulating a reform agenda in any detail.
The UK is not alone. There is a growing list of policy errors around the world. The pressure for higher spending is high in the US, where the Biden administration cancelled student debt. The German government is circumventing its own fiscal rules by constructing a large energy related spending package. Italy has elected a populist coalition.
Outside of the developed markets, the picture in emerging markets is not especially comforting. China has persisted with it’s zero Covid policy while the construction sector – its largest single contributor to growth – is struggling. In recent weeks, China has allowed for a depreciation in its currency in a way that is likely to pressure the currencies of its trading partners in the region.
Where does all of this leave the markets? What is needed to stabilise markets is visibility around the point at which policy interest rate increases will end. To get there, we need to see two developments. First, a stabilisation in measures of long-term inflationary expectations. Second, actual inflation figures to start declining. But if fiscal and monetary policies are tugging in opposite directions, it will be difficult to see how these conditions can be achieved in the near term. A likely outcome is that monetary policy will continue to be tightened until a recession is in full swing, and unemployment is rising.
Against this background, equity markets are likely to see further downside in the weeks ahead. Dislocations in bond markets, however, have started to expose opportunities. This said, short term bonds continue to offer a better risk – reward balance than either credit or longer duration. Emerging markets are perhaps the least attractive segment of the market, as the cost of external financing rises, liquidity conditions tighten and currencies weaken.