Persistent inflation poses a challenge for central banks

Global growth momentum is losing steam and inflation is at levels last seen in 1990s. Despite the macroeconomic headwinds, the third quarter earnings season surprised on the upside and stock markets are at record highs. Inflation has, however, turned out to be more persistent than central banks expected. Can inflation be tamed without turbulence in the financial markets and in the real economy?

Global economic growth surprised on the downside in the third quarter. Coronavirus spreading in unvaccinated communities, pandemic related disruptions in supply chains and in the labor markets and soaring energy prices hit hard many economies around the globe.

In the US GDP expanded by only 0.5% from the previous quarter, slowing down from above 1.5% quarter-on-quarter growth during the first and second quarter. Private consumption was dampened especially by falling car sales and fixed investments were flat. Inventory build-up contributed the whole GDP growth, which implies weak support for GDP growth from inventory investments in the following quarters.

Chinese GDP growth has been remarkably weak during the current year. Chinese statistics must obviously be taken with a grain of salt. The figures usually show what the government wants to tell. The third quarter growth from the previous quarter was only 0.2%, and during the three quarters of 2021 the Chinese economy has grown only by 1.5%. This is a stunningly weak performance, and raises the question, what is the message the Chinese government wants to tell? The government’s year-on-year growth target for the current year is 6%, which is fairly low at Chinese standards. Even with this meager growth during the current year, the government’s target will be reached. Technically, weak developments during the current year imply weaker year-on-year growth figures for the next year.

The loss of growth momentum in China is related to global drivers such as supply disruptions, but China has also domestic problems, such as turbulence in the important property sector, energy shortages due to soaring coal prices and zero tolerance to COVID infections. The government’s aim to foster inclusive growth – common prosperity in Chinese terminology – which includes a crack down on billionaires may also have slowed down growth in the world’s second largest economy recently.

In the Eurozone the third quarter growth was exceptionally strong at 2.2% from the previous quarter according to preliminary estimates. Household consumption was the main driver of growth. Increasing vaccination rates and the easing of COVID containment measures supported economic activity. Economic growth was strong in France, Italy and Portugal, whereas Germany suffered from supply disruptions in manufacturing industry.

First economic indicators from the fourth quarter display stronger developments in the US. The Purchasing Managers Index, which tracks the current economic activity, improved markedly in the service sector in October. The October jobs report showed stronger than expected monthly job growth. Employment rose by around 530 000 persons and data for August and September was revised up by around 250 000 persons totally.

In the Eurozone the level of economic activity is, however, lower than during previous months and moderation of the growth rates is expected. The fastest recovery phase is over, supply chain problems are holding back manufacturing, support from fiscal policy is waning and rampant inflation is weakening households’ purchasing power.

In China, the zero tolerance policy to COVID continues and is a threat to short-term growth prospects. It is also a risk to global growth, as a handful of COVID cases can close whole industrial areas or large export ports. The global growth performance in the fourth quarter is obviously heavily dependent on the development of the pandemic.

The stock markets retreated earlier in the fall as inflation worries intensified, the Chinese real estate giant Evergrande had problems in meeting its obligations to bondholders and the debt ceiling negotiations in the US were heading towards a dead end. During the recent month stock markets optimism has returned. Volatility indices have fallen back to low levels and broad stock market indices in the US and in Europe have reached all-time highs again. What is behind the return of investor optimism?

In the third quarter earnings season the majority of companies have beaten forecasts both in the US and in Europe. Both revenue and earnings exceed analysts’ expectations at the aggregate level. This implies that supply-side disruptions and increased material and other production costs have had smaller impact on companies than was expected.

Importantly, this also suggests that companies have been successful in passing higher production costs into their output prices and thus protecting their profit margins. This is obviously good news for the companies and stock markets in the short run. The flip side of the coin is that consumer price inflation goes up and adds to problems the central bankers are facing.

Strong earnings season lifted the mood in the stock markets. At the same time bond market volatility increased as continued price pressures and energy price spikes worried investors. Short-dated government bond yields have edged higher in many countries. Two-year bond yields, which are sensitive to changes in the expectations of future monetary policy soared especially in the US, UK, Canada and Australia after higher inflation figures moved market expectations of central banks’ first interest rate hikes forward. For investors, higher bond yields imply lower bond prices.

Yield curves have flattened as long rates have not moved up as much as the short rates. The flattening can be interpreted as signaling a stagflationary story, where long term growth expectations remain weak. At the same time, low long term interest rates reveal that investors do not expect the current high inflation to become sustained.

The Eurozone inflation hit 4.1% in October. During the whole monetary union period starting from 1999, inflation has been this high only for one summer month of July in 2008 just before the Great Financial Crises broke out. Sounds really bad, but one gets a less alarmist view of the current situation by looking at the contributions of the main components of consumer prices. Half of the current inflation is coming from energy prices, which are almost 25% higher than 12 months ago. Inflation excluding energy is currently at the ECB’s target of 2.0%.

In the US, inflation is more wide spread. October inflation published last week jumped to 6.2%, which displays a stunning acceleration from 5.4% in September and the fastest pace since year 1990. The core inflation excluding the volatile food and energy prices was up by 4.6%.

Inflation has turned out to be much more persistent than the central banks have communicated to the markets during the current year. So, no wonder the markets are currently challenging the central banks’ pledge to keep the steering rate low for long.

Even though the Federal Reserve in the US has already decided to start tapering the large asset purchase program and has taken the first step in the marathon of monetary policy normalization, there is a long way to go before steering rates go up. In recent speeches, Chairman Powell quite expectedly have pushed back market expectations of the first interest rates hikes taking place already next summer.

The Federal Reserve has already admitted that the narrative of transitory inflation was not correct, and that the supply chain disruptions and the related price pressures are likely to stretch well into the next year. The ECB has been more reluctant to admit that their assessment of the inflation process was wrong.

The third major central bank in the world, The Bank of Japan just vowed to keep the ultra-loose monetary policy stance in place as long as it is needed. In Japan inflation is still close to zero and there is a long way to go to reach the 2% inflation target.

So, market participants expecting higher central bank rates will be disappointed. I am quite sure that major central banks will patiently look through higher inflation. Provided that supply side disruptions are a major contributor to inflation, central banks do have a fairly good reason to continue the ‘wait and see’ policy. Monetary policy operates through the demand side of the economy, and central banks do not have any tools to tackle the supply chain disruptions and labor market tightness directly. This is not, however, the whole story. Central banks could curb aggregate demand with tighter monetary policy and thus improve the supply-demand balance and ease inflationary pressures. This is something the central banks will not do.

Major central banks of the world, that is The Federal Reserve, the ECB and the Bank of Japan, will wait until next summer to see whether inflationary pressures are receding. Meanwhile, only small tweaks to the asset purchase programs are to be expected. The Fed may speed up or slow down the tapering process which started this month depending on the growth outlook. The ECB in turn needs to step up its asset purchase program when the pandemic emergency purchase program ends in the spring.

What are the implications of the central banks’ ‘wait and see’ policy for investors? Even though the central banks’ cautious policy towards inflation may be justifiable, there is a real risk that the inflation genie is out of the bottle. It doesn’t really matter what is the initial reason for higher inflation. If market participants, households and wage setters are expecting high inflation to persist, the changes in their behavior will guarantee that high inflation will linger.

The central banks will not tighten monetary policy and take away the punch bowl from the investors’ party anytime soon. In the short run this obviously supports equity valuations.

Provided that the central banks are right this time and inflation will gradually ease by next summer, loose financial conditions will continue to support the markets and the real economy. This is the benign scenario.

However, the probability of a policy error has increased, as inflation has turn out to be more persistent than was expected by the central banks. If inflation is hereto stay, next year central banks will be ‘behind the curve’ and the needed policy action to tame high inflation will be harsh for investors, firms and households. Monetary policy impacts inflation through economic activity and with a long lag. So, in order to curb real investments and consumption, and to bring down price pressures, expected real interest rates need to go up. And this happens only when the steering rates are hiked more than expected inflation rises.

Abrupt rate hikes would drive the economies into a recession and would hurt investors through repricing of risky assets. Higher rates would also imply markedly higher debt servicing costs to many heavily indebted governments. This second scenario would be bad news for the markets and for the economies in general.

So, let’s hope that the central banks got it right this time and inflationary pressures will ease gradually.

November 18, 2021
Anssi Rantala
Senior Advisor / Chief Economist