In most developed countries inflation is exceptionally high. It is widespread – it affects the vast majority of the components of the consumer price index – and, what’s more, it is persistent, as statistical analysis shows. It should therefore take time to return to a level in line with central banks’ objectives.
Central banks have finally reacted after having been surprised by the surge in prices. The Bank of England has already made several rate hikes, while the US Federal Reserve has shown strong determination to curb inflation through an aggressive tightening policy (rapid and significant rises in the rate of federal funds, and a reduction in the size of its balance sheet). Finally, the European Central Bank (ECB) is preparing for an increase in its deposit rate, either from its July meeting, otherwise in September.
Initially, the actions of central banks will be applauded. Indeed, households are complaining about the pressure exerted by the sharp rise in prices on their purchasing power. In the United States and the eurozone, this explains the fall in consumer confidence, a development which is worrying for future spending patterns. Companies too are complaining about rising input prices, long delivery times and labour shortages. In the US, the ratio between job vacancies and job seekers is unusually high, which is leading to a sharp acceleration in wage growth. Up to now, companies have not found it too difficult to pass on the increase in their costs to their sale prices: demand is sustained, the order book is full and price elasticity of demand is low. But that shouldn’t last long. The objectives of a less accommodating monetary policy are to slow growth in demand and to reduce the transmission of rising costs to sale prices.
At some point, the steps taken by central banks will therefore be called into question. We can already pick out several dilemmas ahead. First, the Federal Reserve will have to choose between the umpteenth rate hike, and risk causing a recession, or stop hiking, and risk inflation not dropping enough. Less acutely, the ECB will be confronted with similar issues. For government bond investors, the question is knowing when to enter the markets. With break-even inflation rates already high, the risk of further sharp rises seems limited. However, if central banks cause surprise by tightening more than currently expect, long-term rates could rise further.
Investors in risky assets (equities, corporate bonds) have to choose between a scenario in which inflation begins to decline – causing a fall in inflation expectations, and therefore long-term rates, and a downward revision of the outlook for monetary tightening – or an increase in recession risk following very restrictive US monetary policy. Finally, businesses and households are faced with another dilemma: invest or consume, counting on a soft landing, or wait for a clearer picture, at the risk of contributing to the economic slowdown.
These different scenarios share the need to understand the future evolution of the inflation-growth relationship. Will inflation fall fast enough and would the slowdown in growth be limited enough? Or should we fear a stagflation scenario with falling growth and inflation that remains high? We do not expect this latter scenario – and nor is it the consensus of economists either – but we should keep it in mind as a possibility.
Investigating economic actors’ reactions to these multiple dilemmas is particularly important due to the knock-on effects – increasing pessimism about growth prospects would, for example, weigh on investment and the stock market, which would lower long-term rates – but also because they may lead to non-linear behaviour when the probability of either scenario rises sharply.
Reproduced with the kind authorisation of L’Agefi
L’inflation va mettre les investisseurs devant de multiples dilemmes – L’AGEFI
