With central banks on hold and offering guidance that the next move in policy may be to cut interest rates, financial markets are behaving as if the inflation fight has already been won and at little cost to economic health – unemployment remains very low by historical standards amid lower, but not worrying, levels of economic growth and relatively robust investor confidence.
While higher inflation has historically weighed on the performance of both bonds and stocks, the situation today goes against those precedents. More than one stock market is trading near all-time highs, but ‘safe haven’ bonds remain close to their lows following the market declines of 2022.
As a result, the debate around inflation remains live and centres on whether, if at all, the dynamics of price pressures have altered in recent years.
What markets tell us
The view priced within bond markets has evolved in recent months but asset prices suggest that inflation within developed markets is likely to glide down towards the central banks’ target of 2% this year. This will allow policymakers to ease monetary policy from the current restrictive levels and limit the fallout to the broader economy of higher interest rates.
With the yield curve inverted – debt with shorter maturities yield more than longer-dated debt – the bond market suggests that the current expected path of monetary policy, alongside a maturing economic cycle, will likely lead to a mild recession. That said, this view is less obviously priced in more recently given the on-going upward surprises from the economic data.
This conclusion of benign inflation, lower (but not collapsing) growth, and supportive official policy has become the consensus. The notion of a so-called ‘soft landing’ in the US – victory over inflation while avoiding a recession – which seemed unrealistic only a year ago, looks within reach. Earnings growth could re-accelerate as inflation comes down to meet central bank targets, allowing for both bonds and equities to perform.
Can rate expectations be wrong?
However, it’s essential that investors remain aware of the risks to this narrative, particularly as the markets have been wrong several times in recent years with growth and inflation surprising on the upside.
Indeed, the resilience of developed market economies (especially the US) to a significant degree of monetary tightening in 2022 and 2023 has reignited the discussion on where the neutral, or equilibrium, rate of interest currently sits.
The neutral rate of interest is a nebulous theoretical concept and the subject of fierce debate. It is closely related to economic growth and is also the interest rate that balances an economy’s supply of savings with demand for investment. Both are influenced by a wide range of factors operating over different time horizons.
It is widely accepted that monetary policy acts with a lag effect – the economic effects aren’t immediate. But if neutral rates of interest are now structurally higher, current policy rate levels may not be as restrictive as central banks think.
This means policymakers need not reduce interest rates as quickly, or as much, as is currently expected.
How inflation can still surprise
In terms of inflation specifically, the majority of the Covid-induced supply bottlenecks have been overcome, allowing goods-price pressures to ease, while there are also signs that the labour market is loosening – alleviating some of the wage and service-sector inflation.
The markets appear confident that these trends will persist and, as such, inflation expectations will continue to be contained as headline inflation plateaus close to 2%.
The threats to this view, however, are numerous and justifies the recent pragmatism shown by US central bankers when they emphasised the need to be data dependent, rather than date dependent, when making decisions.
Keen to avoid the policy mistakes made by their predecessors at the Federal Reserve (Fed) in the 1970s and 1980s, they do not want to loosen policy prematurely while inflation remains a threat.
Whether it be renewed threats to global supply chains, an escalation of geopolitical tensions, costs associated with the climate transition or labour-market dynamics, there are a host of reasons to believe that inflation may not be completely under control.
Rates - higher for longer?
A focus on the risks of stubbornly higher inflation, rather than the damage to labour markets that a period of sustained high policy rates may cause, could cause central banks to err on the hawkish side – keeping rates higher for longer. Fed Chair Jerome Powell has expressed his concerns about the prospects of easing too soon.
If central banks wait too long before ‘normalising’ interest rates, it’s possible that we will have not only an economic downturn, but one that is exacerbated by an overly restrictive policy stance that cannot be loosened quickly enough when the economy slows too much.
Inflation tends to support stocks and bonds while it is falling towards the 2% target, as it generates hopes for more accommodative policy. If inflation falls below target the consequences have historically been more negative, in large part due to the typically associated contraction in growth.
Even further falls in inflation (below target) would hurt earnings expectations if driven not by a recovery in the supply side of the economy, but by insufficient demand and its implications for business activity and consumption. Equities would sell off. But in this scenario ‘safe haven’ bonds should do well amid policy easing.