investment insights

    Inflation remains a moving target for central banks

    Inflation remains a moving target for central banks
    Samy Chaar - Chief Economist

    Samy Chaar

    Chief Economist
    Homin Lee - Senior Macro Strategist

    Homin Lee

    Senior Macro Strategist

    Key takeaways

    • Until recently, inflation consistently fell short of central banks’ targets. It then dramatically overshot as the effects of Covid and the Ukraine war were felt
    • Inflationary pressures including changing supply chains, labour shortages and scarcer commodities should be offset by disinflationary factors such as demographics and advances in AI. Central banks will only raise inflation targets once public expectations shift to accept slightly higher levels
    • The tightening cycle is about to end, but it will not reverse in 2023, with US and eurozone rates peaking soon and inflation still above Fed and ECB targets. Central banks need to maintain high rates to allow the hiking cycle to fully filter into their economies
    • With interest rates close to their peak in the US and Europe, and growth slowing, we favour sovereign bonds and investment grade credit in our fixed income exposures.

    After decades of undershooting central banks’ inflation targets, over the past 18 months prices have risen four or five times faster. We expect central banks to implicitly accept slightly higher inflation, and they may only explicitly change their targets in the years to come.

    To keep economies running smoothly, central banks in the developed world have settled on a steady, annualised 2% inflation target. The number seeks to strike a balance between leaving space for economic growth, without scaring consumers from spending, firms from investing or eroding the value of inventories. It also leaves policy makers some margin for real rates to fall to zero, or lower.

    When prices rise too far, either because of higher production costs or higher demand, purchasing power, capital investments and mortgage payers all suffer. As we have experienced since the pandemic, that creates a vicious circle in which employees understandably expect their wages to keep pace with prices. Once that happens, only changing expectations, coupled with higher borrowing costs, can break the pattern and let inflation moderate. Conversely, Japan suffered from the opposite problem of ultra-low inflation for decades. It now looks to be accepting higher prices without yet adjusting its ultra-loose monetary policy under a new governor.

    Inflation targeting was only added to the monetary policy toolbox three decades ago

    Inflation targeting was only added to the monetary policy toolbox three decades ago. As part of their efforts to influence public expectations and show that central bankers were addressing the high inflation of the early 1980s, policymakers in Italy, Greece and Portugal set individual inflation targets on an annual basis. The first long-term target is usually traced to a process started in 1988 at the Reserve Bank of New Zealand that culminated with a March 1990 ‘Policy Targets Agreement,’ which took aim at a range of zero-to-2%, then 0-3%. Almost all key central banks including the US Federal Reserve (Fed), Bank of England, the European Central Bank (ECB), the Bank of Japan, and their peers, have since adopted their own targets.


    Forward guidance

    Even where central banks set targets, they were not necessarily explicit nor, in the interests of credibility, rigidly applied. At the Fed, Alan Greenspan resisted the idea of an explicit commitment, in line with his 1987 comment to the Senate that he had “learned to mumble with great incoherence” since becoming a central banker. When communication policy changed under Mr Greenspan’s successor, Ben Bernanke, the Fed turned an implicit goal into an explicit 2% target in 2012. US inflation then fell persistently short of that target. It only overshot in early 2021, when Covid’s health restrictions lightened, taking inflation to its highest levels since the early 1980s.

    Still, inflation ‘target’ was always a misnomer. Monetary policy’s effectiveness depends on clearly communicating, and ‘anchoring,’ expectations. But like any best intention or New Year’s resolution, just because a central bank has an inflation target, it does not mean that investors can assume that is where an economy will head. In August 2020, the Fed shifted to a “flexible average inflation target” of 2% “over time.” Applying a similar logic as inflation rose, a year later, the European Central Bank (ECB) changed its target to a “symmetric” 2%, meaning “that it is equally undesirable for inflation to rise above or drop below the target”.

    Inflation ‘target’ was always a misnomer

    Balancing out?

    In the current environment it is not hard to think up a list of long-term inflationary pressures: from the rising cost of production and duplication of supply chains, labour shortages, scarcer resources and investments in the sustainability transition. On the other hand, technological advances, including artificial intelligence (AI) and robotics, as well as ageing populations with more savings, all add disinflationary factors to the mix. It is unclear if these long-term disinflationary factors will be enough to stop prices from being more volatile over the coming five to ten years.

    To reach 2% inflation from the peaks of the past year, central bankers would have to raise rates to uncomfortable levels for borrowers, homeowners and voters, as well as stall economic growth into a deep recession. That has far-reaching social and political implications, as it demands a trade-off between inflation that erodes purchasing power and higher rates that make borrowing expensive. The social damage has manifested itself in extensive protests and labour strikes in many economies. 

    These concerns are partly why interest rates are likely to peak in 2023. More than a year after the first rate hike, we expect the Fed to deliver a further 25 basis point increase on 3 May, and, depending on stresses in the banking system, possibly another in June. That would take interest rates to around 5.5%, which we believe will be the peak in this hiking cycle. We expect weaker US economic growth over the rest of 2023 with gross domestic product expanding 0.9% for the full year. Growth is almost entirely driven by services and consumer spending, which are dependent on the still-strong labour markets. However, interest rate sensitive sectors and cyclical sectors such as manufacturing, trade, investment, private sector loans, money supply and real estate, all look weak. A mild US recession is therefore the likely cost of bringing inflation to more acceptable levels, and the risks of a major economic contraction are low. The ECB is on a similar path, with a lag of at least six months. We expect eurozone GDP to reach 0.7% in 2023, and rates to peak around 3.5% from today’s level of 3%.

    A mild US recession is therefore the likely cost of bringing inflation to more acceptable levels

    A tolerable range?

    US and eurozone inflation will still be above target; the Fed forecasts consumer inflation reaching an annualised 3.3% by the end of 2023, and slowing to 2.5% in 2024. After the four-decade-high levels of the past year, 3% inflation at the end of 2023 is likely to be politically acceptable. Former Fed Chair Paul Volcker left office in 1987 credited with bringing US inflation under control over eight years. At the time, inflation was running at an annualised 4%.

    Once US interest rates peak, the debate around how fast America’s economy can return to a ‘neutral’ level will quickly follow. Given the lag in impacting the real economy, we expect rates to stay on hold into 2024. Then, early next year, and absent a new shock that demands an immediate response, the Fed should begin the process of reducing rates to a level closer to 2.5% or 3%.

    We believe that, after decades of low rates and undershooting inflation targets, inflation’s ‘new normal’ will be higher. Over time, inflation in the US will far more probably land in a 2.5% to 3% range. Indeed, surveys indicate that consumers expect inflation in the long-term to fall around this level. In our view, central banks will implicitly accept this range, and only consider explicitly raising their targets many years from now, and only once such levels are ‘anchored’ in public expectations. This may even be implied in the Fed’s average inflation targeting framework.

    Central banks will only consider explicitly raising targets once higher levels are ‘anchored’

    Global growth is slowing under the strain of restrictive monetary policy. With the tightening cycle filtering into the wider economy, interest-rate sensitive sectors including manufacturing, private investment and housing, will all continue to weaken. Credit conditions have already tightened after March’s banking turmoil, however we do not anticipate severe financial stresses as authorities remain vigilant.

    We continue to closely monitor inflation and growth risks. With the inflation fight still underway, we maintain a prudent investment approach in our clients’ portfolios. For equities, elevated but falling inflation can support nominal revenue growth for now, with less pressure on valuation multiples from high but stable rates. However, profit margins, which have already contracted, can fall further as activity slows, and the severity of the slowdown will be a key variable for corporate profitability. As we close on a peak in US interest rates, we have increased exposures to fixed income because the case for owning high quality bonds, including US Treasuries and investment grade credit, is strengthening in a disinflationary and slower-growth environment

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