Forget Overkill. Central banks are still far behind.
This combination is why expected real rates – conventional bond yields minus expected inflation – have soared. Perhaps unsurprisingly, the UK leads the pack and over the past year five-year expected real yields have risen by five percentage points. But the surge in expected US real yields is not far behind. This dizzying rise has worn down financial assets and led to all the whispers about overpowering. The extraordinary thing about rates, however, is not how high they are, but how low they are. They will have to increase much more to bring inflation down sustainably.
A big reason for the expected decline in inflation is that investors big and small were used to a world in which disinflation seemed more of a problem and believe it won’t take much to bring it back. The same goes for central banks and, strange as it may seem, they still have a lot of credibility.
Broadly speaking, these views are supported by three main arguments. The first is that you can’t get much inflation given the unprecedented amounts of debt outstanding in the world today. What people generally mean by this is that the cost of servicing all that debt at higher interest rates would quickly eat away at demand and therefore growth. However you launch the argument, it is wrong. Simply put, if nominal growth is much higher than nominal rates, debtors are in heaven and creditors in hell. There are exceptions, such as heavily indebted companies, governments linking many pensions to inflation, or UK households borrowing at floating rates. But surprisingly high inflation mainly hits creditors. Look for evidence of appalling real bond returns over the past two years.
The second argument is that the amount of money circulating in developed economies is rapidly slowing down, stifling growth and inflation. The problem with this argument is twofold. The first is that it confuses stocks and flows. While monetary growth is indeed slowing, the stock of money remains very high. The second is that monetarists are not good at accounting for the velocity of that money, or how fast it flows through the economy. After falling like a rock for many years, the velocity is picking up, supporting inflation pretty much by definition.
The third argument is that a slowdown in economic growth will lower inflation rates. Granted, most of the developed world has slowed down and China has fallen into a very deep hole, reducing global demand. The Bloomberg Commodity Index is down more than 15% since June and West Texas Intermediate oil prices are down about 25%. Combined with energy price caps in many countries, this should reduce headline consumer inflation.
But I highly doubt that the slowdown in growth will be enough to bring inflation back to the level markets expect, let alone the extent of its spread since the initial supply shocks. In any case, the inflation forecasts of central banks and markets should be viewed with healthy skepticism. Both have systematically and dramatically underestimated the inflationary surge of the past two years. Even now, all that has really changed is that they have postponed when inflation rates will fall, the level from which it falls, and the interest rates needed to bring it down.
Maybe the reason they’re so wrong over the past two years is that they’re misdiagnosing both what happened in the 1970s and what happened in recent times. years. The inflation of the 1970s began long before the first oil shock and continued long after its effects wore off. Inflation has become such an intractable problem because over the years it has spread to every nook and cranny of the global economy. There are a lot of similarities this time around, but with a twist. Headline inflation has been driven down for many years by falling prices of traded goods. Central banks reacted by keeping their foot firmly on the monetary stimulus pedal, even though interest rates had virtually no effect on tradable goods prices and there were no signs that the fall in the prices of traded goods led to a fall in domestic inflation, as in the provision of services. It probably meant the opposite. Wage inflation, after all, has been rising for years. Over the past two years, headline inflation has both widened and increased. Take the consumer price index in the United States. The median reading has fallen from less than 2% in January 2021 to 5.8% currently. Lately, the rising median has been marked by much higher prices for services than for goods.
If the world were left with interest rates that were way too low for too long, the recent and expected moves would only undo some of that. Although the markets expect real rates to be very positive going forward, it mostly depends on whether they are right that inflation will fall very sharply. For now, the gap between short-term rates and inflation has never been wider. This is why one would be hard-pressed to find a model that produces a rate required to slow inflation to anything like their current levels. Take, for example, the well-known Taylor’s rule. You can roughly get a 5% rate in the US if you bias the inputs enough. Under more reasonable assumptions, rates should be in the order of 10%. For the United Kingdom and the eurozone, they should be even higher under all assumptions.
The dead hand of past bad monetary policy decisions is also evident in the surprising lack of movement in longer-term bond yields, with the exception of UK government debt. One of the main reasons why they have not increased is that, thanks to enormous quantitative easing and foreign exchange intervention over the past two decades, central banks now hold a huge amount of government debt in Classes. Much higher long-term yields would have helped ease inflationary pressures. In the absence of such a rise in long rates, central banks will have to make greater efforts with short rates.
All of this would only need to be half true for the current rates to be completely wrong. I simply cannot imagine Karl Otto Poehl, the president of Germany’s mighty Bundesbank since 1980, being anything but mocking about what is currently fixed in the markets. As Germany showed from the 1970s, the monetary response to inflation is important. Expect more than whispers in the coming months. More from Bloomberg Opinion:
• The problem of telling the Fed to stay the course: Clive Crook
• The BOE risks snatching defeat from Jaws of Victory: Marcus Ashworth
• UK turmoil brings back bond vigilantes: Mohamed El-Erian
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Richard Cookson was Head of Research and Fund Manager at Rubicon Fund Management. Previously, he was Chief Investment Officer at Citi Private Bank and Head of Asset Allocation Research at HSBC.
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