Market Review: On Inflation, Central Banks and Monetary Policy

Allan Eriksén, Strategist and Portfolio Manager, UB Asset Management

A year ago, the distribution of coronavirus vaccines had just begun and faith in crushing the pandemic was strong. Forecasts on economic growth and corporate profits were rising sharply, and interest rates were still at record lows. Inflation had only just begun to normalise after the pandemic and the US Federal Reserve had announced the previous year that it would move towards a new average inflation targeting in monetary policy, under which a temporary, and even a sharp rise in inflation would not automatically lead to monetary policy tightening. 


The capital markets were pleased about the unusually positive conditions and continued to rise. The first note of discord was obtained from the US sovereign debt market, where interest rates on the longest bonds already started to rise in the spring of 2021 from historically low levels after the pandemic. Short-term interest rates did not react because inflation was seen as moderate and transitory, and after all, the US Federal Reserve had promised not to overreact to potentially rising inflation.


In the summer of 2021, US consumer price inflation already rose to over 5%, but the interest rate market remained calm. The stock market continued to rise, supported by strong earnings growth and increasingly negative real interest rates. In the early autumn, persistently rising inflation rates, not only in the USA, but also in Europe, began to gain attention. However, central banks continued to reassure markets on the transient nature of inflationary pressures, although in September the Fed DOTS already indicated several rate hikes by the end of 2023.


As we approached Christmas, the US fixed income market finally reacted, with the November inflation figure approaching 7%. Consumer price inflation in the euro area had also risen to almost 5%. These numbers were the highest in 40 years. The development culminated in the Federal Reserve's December meeting, where Chairman Powell indicated that the assumption of the rapid passing of inflation was being discredited, and that the central bank will apparently have to tighten monetary policy much faster than expected. In the current year, the Federal Reserve has increased the pressure on financial conditions even further and, somewhat surprisingly, also prompted the European Central Bank to tighten its guidance clearly.


Why does the change in the direction of central banks' monetary policy matter? Since the financial crisis (2008-2009), inflation in developed countries has consistently remained below central bank targets. As a result, the key interest rates were first lowered close to zero, followed by quantitative easing (QE), under which central banks still buy government bonds, effectively with money they themselves create. Over the decade before the pandemic, financial markets have become accustomed to low inflation, even lower nominal interest rates and, as a result, negative real interest rates, which were further stimulated by the pandemic. This has clearly increased the attractiveness of almost all other asset classes and is also likely to have increased valuation levels. A clear reversal towards tighter monetary policy could, in turn, erode the attractiveness of e.g.  stocks and real estate, thereby reducing valuation factors.


Why does inflation matter?  If the inflation we are experiencing today would suddenly disappear, it would only have had a temporary negative effect on consumers' purchasing power, without causing severe long-term consequences. That is exactly what was expected to happen at first, but as inflation has now quickly exceeded the expected level and duration, the situation of central banks is becoming difficult. A key problem relates to the psychological effects of inflation.


It is known that allowing inflation to remain well above the set targets for a longer period will begin to take root in people's minds. There is talk of rising inflation expectations. This in turn affects individuals' assumptions about the future, and can lead to increased wage demands, cost increases, and a further increase in inflation. It is also known that reversing the rise in inflation expectations would require a much tighter monetary policy, i.e. higher interest rates.


Central banks are in a situation where, after waiting too long for inflation to dissipate on its own, they now must tighten monetary policy more strongly than expected to prevent inflation expectations from rising uncontrollably.


So far, inflation expectations have remained moderate, and the market assumes, despite interest rate hikes, that central banks do not want to create a monetary policy survival game. Higher interest rates have mainly been reflected in a clear fall in the share prices of companies and industries which had the highest valuations and the most uncertain profit outlook. Broad stock indices have fallen only moderately.


The key challenge for central banks in 2022 is therefore to strike a balance where a sufficiently stringent monetary policy prevents inflation expectations from rising but avoids an overly tense monetary policy that would cut economic growth and potentially trigger a recession.


Grossly simplified, there are two possible paths ahead. In a more comfortable option, which is currently supported by the market, inflation will, as expected, begin to fold over during the spring as the specific causes related to the pandemic recede, and a normalisation of inflation by the end of 2023 will start to look likely. In this case, the tightening of monetary policy will remain less aggressive than what the US Federal Reserve is currently indicating. Interest rates may even fall, economic growth will remain healthy and stock markets will be doing well.


However, if inflation proves to be clearly more resilient than expected, central banks will have to tighten monetary policy significantly more than the current estimate, to avoid persistent inflation expectations taking root. As a result, long-term interest rates may rise sharply, which in turn would put pressure on valuation factors and prices on the capital markets. Economic growth forecasts would also be under downward pressure.


An inflation environment like today has not been experienced since the 70s and 80s. For a long time now, central banks have mainly been fighting deflation with an extremely supportive monetary policy. Let us hope that they are up to speed in a changing environment and manage to stabilise inflation without dramatic action, maintaining calm in the economy and capital markets.


The information presented is based on United Bankers' own assessments and sources considered reliable by United Bankers. The information on which the conclusions are based can change rapidly, and UB can change its market views without notice. As such, no information obtained through this presentation should be understood as an invitation to take investment measures.