This article appeared in the Sunday Times on 24th April 2022.
While the focus has rightly been on the humanitarian tragedy from Russia’s invasion of Ukraine, the conflict has complicated what was already a difficult task for policy makers: how quickly to remove the stimulus initiated during the pandemic. Central bankers face a delicate balancing act between reducing inflation but not causing a recession.
How successful they are, is likely to be critical for financial markets this year.
COVID-19 had already provided a challenge for economic policy. Without any recent historical precedent of pandemics there was significant uncertainty as to how long-lasting the economic effects would be. Policy makers erred on the side of caution, reducing interest rates and initiating various measures to support incomes. When the vaccines were rolled out and economies started to reopen, the effect was a strong V-shaped recovery that confounded many forecasters.
However, not all parts of the economy recovered to the same extent. Some parts of the global supply chain, such as the production of semiconductors, failed to keep track with the burst in demand for consumer goods, resulting in a rise in inflation. Initially, the consensus was that inflation would be transitory, but that proved not to be the case. Supply side disruptions lingered as lockdowns in certain markets like China have continued and there have been periodic disruptions to energy supply.
As inflation remained stubbornly high, central banks around the world have been forced to abandon the gradual approach to monetary policy. Last month, the Federal Reserve increased rates for the first time since 2018 and the European Central Bank signalled a tapering of its asset purchase program, a move seen as preparing the way for an eventual rate rise.
One reason for the about turn is the rising cost of living has become a major political issue. In the US, President Biden announced in his State of the Union Address that dealing with inflation was his top priority.
However, the Russian invasion of Ukraine, has complicated the task as many commodity markets such as crude oil and wheat have been disrupted as the global economy adjusts to a scenario where supplies from Russia, and to an extent Ukraine, are removed from the global market.
The problem is that these moves represent a supply shock for the global economy, in the same vein as the two oil crises of the 1970s. Higher food and energy prices will put upward pressure on inflation in the months ahead and will reduce real disposable incomes providing a headwind for consumer spending. The net effect is potentially the worst scenario for the global economy: slowing growth and rising inflation, or stagflation.
For much of the last decade financial markets have been used to what economists called the “Goldilocks economy” – not too hot but not too cold. That provided a favourable backdrop for financial assets like bonds and equities, particularly as it allowed central bankers to reduce interest rates and provide liquidity to markets on any sign of economic weakness.
That pattern of behaviour from central bankers strengthened investors’ belief in what they call the “Fed put”, the idea that the investors effectively had a free option investing in equities as the Federal Reserve would have to respond if equities fell to a certain level. Indeed since Alan Greenspan intervened to provide liquidity after the 1987 stock market crash, each major equity market sell-off has been met with lower interest rates.
However, this time may be different. We have already seen increased volatility in equities this year, particularly in highly valued growth stocks, yet central bankers appear to be becoming more resolute about addressing inflation. In financial markets, the concern is now that they may overdo the tightening.
The job for central bankers in this cycle is complicated by the fact that they have accumulated trillions of dollars in assets as part of the quantitative easing (QE) policies over the last decade. As part of the process of removing monetary stimulus they now plan to reduce their asset holdings – what is called quantitative tightening (QT).
Whereas QE was designed to boost financial asset prices, QT will be a headwind for financial assets. The last time they tried this in 2018 equities fell sharply and US money markets became disrupted in 2019.
In short, while it has been a volatile start to the year for many markets, the big hurdles may lie ahead when central bankers start to address their enormous balance sheets while raising interest rates, at time of slowing economic growth.
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