The message from market-based indicators and core inflation data is that the worst of the inflationary pressure may be behind us.
Is a U.S. policy error ahead?
If the U.S. Federal Reserve (Fed) continues to tighten well after inflation pressure has eased, this could be a policy error with very serious consequences.
The world is watching
As the central bank of the reserve currency, the Fed could pressure the entire global system if it tightens too much.
Global developed market central banks have been clear that they are laser focused on inflation. Indeed, U.S. Federal Reserve (Fed) Chair Jerome Powell recently said that the biggest risk facing the Fed is failing to restore price stability and that the Fed is strongly committed to using its tools to cool prices. The impression we are left with is that the Fed has completely bought into the current zeitgeist that the singular threat to the global economy is inflation. Furthermore, Powell has stated that the Fed will continue to raise rates until it gets clear and convincing evidence that inflation is declining. There is a risk that Powell and other central banks’ focus on inflation could lead the global economy into recession and increase the risk of a financial accident.
We know that growth is slowing, and that Western economies are coming off a massive, policy-driven boom. The light blue line below illustrates that U.S. personal income (Figure 1) boomed during the pandemic as the government implemented multiple rounds of direct stimulus. (The dark blue line illustrates personal incomes without the impact of stimulus and other transfers.) This has now washed through the system, and indeed, real income growth is currently negative, as wages have not kept up with inflation. This is a headwind for consumption and growth going forward.
The impact of pandemic stimulus has washed through the system
Source: Macrobond. Data from Jan. 1, 2017, to May 1, 2022. Personal income without transfers excludes the impact of government social benefits and benefit payments from businesses.
Monetary policy also aggressively and unprecedentedly boosted the global economy during the pandemic. The combination of aggressive rate cuts and quantitative easing boosted money supply and liquidity. As central banks have transitioned to tighter policy in recent months, this support has also dried up. Interest rates have been rising and central bank balance sheets are beginning to shrink. U.S. money supply growth has slowed, and the U.S. M2 money supply actually shrank in April (Figure 2), which is a rare and concerning event.
Tighter central bank policy has led money supply to shrink
Source: Macrobond. Data from Jan.1, 2007, to May 1, 2022. M2 is a measure of the money supply that includes cash and chequing deposits as well as savings deposits, money market securities, mutual funds, and other time deposits.
On top of this, there is a risk that a more abrupt slowdown in U.S. growth may be in process sooner than expected. Real time growth indicators, such as Purchasing Managers’ Index (PMI) data, have begun to decline; anecdotal evidence of inventory buildup and slowing goods demand is increasingly common. As for gross domestic product (GDP), real GDP decreased at an annual rate of 0.9% in the second quarter of 2022, following a decrease of 1.6% in the first quarter.1It may be debatable whether the U.S. is in a full recession, but recent data show that the economy is slowing.
U.S. inflation pressure may be easing
Inflation, which has attracted the attention of the central banks, is very high. Headline inflation is over 8% in both the U.S. and the eurozone, boosted by the sharp rise in commodity and energy prices.2 There are signs, however, that some inflationary pressure is easing. U.S. core inflation, which excludes food and energy prices, appears to now be on a downward track on a year-over-year basis. Market-based estimates of inflation expectations derived from the inflation-adjusted bond market have been declining for several months in the U.S. (Figure 3).
So, the message from the market and core inflation is that the worst of the U.S. inflationary pressure may be behind us. The stimulus-driven demand push and supply chain issues may be easing, and that may allow inflation to decline going forward. In other words, the policy-driven bump up in prices may be passing through the system and prices may ease to their pre-pandemic dynamics.
The market is pricing in a decline in U.S. inflation in future years
Source: Macrobond. Data from Jan. 1, 2020, to July 22, 2022. Breakeven inflation is the difference in yield between a nominal Treasury security and a Treasury Inflation-Protected Security of the same maturity (10 years, 5 years, 2 years). The 5-year, 5-year forward breakeven illustrates inflation expectations over a five-year period but starting five years in the future.
The potential policy mistake
Today’s high inflation is the overwhelming priority for Western central banks, and we believe they are looking for clear and convincing evidence that inflation is declining before they stop tightening monetary policy. In my view, this is a problem. Central banks are watching a lagging indicator, or in the case of survey-based inflation expectations, a moving average of a lagging indicator, to set monetary policy.
The problem is, we know that monetary policy is forward-looking and works with long and variable lags. Setting a forward-looking policy based on lagging data is akin to driving a car by looking in the rearview mirror – prone to serious error. If the Fed continues to tighten well after inflation pressure has eased, this could be a policy error with very serious consequences, and it may not be corrected until a crisis arrives.
As the central bank of the reserve currency, the Fed’s actions are particularly important for the global economy. If the Fed tightens too much, it could pressure the entire global system. We have a long history of such accidents being accelerated or precipitated by a tightening Fed. We had the Latin American debt crisis of the 1980s, The Asian crisis of 1997, and the Russian and Long-Term Capital Management hedge fund crises both in 1998. In 2007, we had the U.S. housing crisis, which eventually made its way to the euro crisis of 2011, which was solved by extraordinary action by the European Central Bank (ECB). A policy mistake by the Fed now could precipitate another crisis — the question is, which one?
A tightening Fed would likely reduce global liquidity — which would be a headwind for many global markets. While emerging market countries are usually particularly vulnerable to reduced liquidity and associated funding stresses, Europe looks quite vulnerable this cycle. The ECB will likely have to raise interest rates to combat inflationary pressure, but at the same time manage the risk that funding dries up for the peripheral European countries, so-called “fragmentation risk.” The ECB is announcing tools that will hopefully help to manage these two potentially competing aims, but the efficacy of these policies is unknown, and the risks of a mistake are real. Managing this tricky trade-off will likely be more difficult with global liquidity tightening led by the Fed.
The bottom line is that a Fed policy mistake is possible, and I believe it would likely be very disruptive for global markets. While it is hard to predict with certainty, the eurozone looks vulnerable to such a disruption during this cycle.
Source: Bureau of Economic Analysis. Data as of July 28, 2022.
Sources: U.S. Bureau of Labor Statistics, as of July 13, 2022. Eurostat, as of July 1, 2022.
Some references are U.S. centric and may not apply to Canada.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss.
Quantitative easing (QE) is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. Tightening is a monetary policy used by central banks to normalize balance sheets.
The Purchasing Managers’ Index (PMI), a commonly cited indicator of the manufacturing sectors’ economic health, is calculated by the Institute of Supply Management in the U.S.
Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.
The opinions referenced above are those of the author as of July 29, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
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