Higher structural inflation

For nearly half a century, global inflation rates have been heading lower.  Since the early 1970s, the world achieved a remarkable decline in inflation, supported by structural factors that included globalisation, better policy frameworks, big demographic changes, and rapid technological advances.  However, since late 2020, the global inflation rate has risen sharply from less than 1% to over 6% due to unprecedented policy support for inflation, the release of pend-up demand, persistent supply disruptions, and surging commodity prices.  

Inflation is today running well above central bank inflation target in almost all advanced economies and most inflation-targeting emerging market and developing economies.  The recent commodity price surge triggered by Russia’s invasion of Ukraine in February is adding to these price pressures.  This persistence of above-target inflation creates a historic monetary policy challenge.  Price stability, generally defined as a low and stable rate of inflation, is a key aspect of the credibility of monetary policy, and of macroeconomic stability.  Low and stable inflation, sustained over time, has generally been associated with robust and stable output growth and employment.  In contract, both very low and very high inflation have been associated with severe macroeconomic problems.

In advanced economies, central banks have so far reacted to the increase in inflationary pressures with a gradual response, tapering off unconventional support introduced during the pandemic and (in some) raising rates.  They have also communicated their intentions to raise rates further in the months ahead.  

Capital markets expect a much shorter and faster cycle of interest rate hikes in the United States than in the past.  Over the next four meetings of the Federal Open Market Committee (FOMC), 175 basis points are expected, meaning that the Fed will have to raise its key rates by 50 basis points several times.  In addition, Federal Reserve Chairman Jerome Powell will start reducing the Fed’s ballooning balance sheet in May 2022.  Both measures are likely to tighten financing conditions in the United States.  Financial markets also expect rate increases by the European Central Bank to start this year.

Arguably, the tools central banks have at their disposal are mostly effective when it comes to demand shocks.  In the current setup, however, the problem is on the supply side, as described above.  The G7 central banks will fight inflation with all means at their disposal, which may also be to the detriment of growth.  As such, the risk of an economic slowdown or even a recession has therefore increased in recent weeks, not least following the release over the past week of a surprise fall in first quarter GDP in the US.

The bright spot in this very delicate situation for monetary authorities is that the value chains are expected to re-synchronise soon and thus the pandemic implications will be weakened.  This remains the consensus view for the second half of 2022, while into the summer, expectations are for a continuously high degree of uncertainty due to stressed value chains, the war in Ukraine and the conflict with Russia.

This scenario is well known to investors and thus reflected to a large extent in today’s prices.  Therefore, it is not surprising that capital markets have already adopted a cautious or bearish positioning.  In fact, data from Bloomberg shows that the number of bulls is as low as it was last seen 30 years ago and the difference between bulls and bears is at a ten year low.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.