Have you just about had it with pandemic-related economic disruption? Join the club—and get ready for more. This week’s much-anticipated monetary policy announcements by the Bank of Canada and the U.S. Federal Reserve Board were preceded by a large market wobble, and will likely be followed by more. The mega-shift in monetary stance should ideally be hailed as a key sign of a widely-desired return to normal. Instead, it seems it’s adding to the tempest. How did good news turn into bad?
This leads to another question: Is inflation good or bad? Most people would say bad, and they’d be right. Inflation distorts decision-making, erodes the value of currency, feeds on itself and at the limit, destroys an economy’s financial system. But prominent market-watchers have challenged the accepted view, suggesting that in the current context, a little inflation isn’t a bad thing. What do they mean? Simply put, the economy is actually growing again at a healthy pace. Demand is pushing the limits on capacity, something we’ve all wanted to see since the onset of the pandemic. So, why then is the market losing its cool?
It’s all happening sooner than expected. In other words: We’re suffering for our own success. With each wave of bad news, the coronavirus swamped us, dashing hopes repeatedly in a way that has coloured our collective view of everything. Most perceived that the economy wouldn’t come back this quickly, that there wasn’t enough fundamental support for a growth surge. This was critically wrong: Business was caught unprepared, central banks were behind the curve and key global policymakers are still priming a fiscal fuel injector that’s flooding the engine, which adds to the supply chain, labour and pricing turbulence.
But there’s more. Elements of monetary policy are still experimental. We had a first crack at the effects of quantitative easing (QE) in the years following the 2009 global financial crisis. It seems to be playing out in much the same way now: The extra liquidity from QE keeps the financial system upright, but really has nowhere else to go. In a downturn, neither businesses or consumers want to borrow—quite the opposite, both go into cash-conservation mode. The question is, where does all that liquidity end up? The jury is still out, but there’s more than one reason to believe that it distorts asset pricing. If so, that means when the tap gets turned off and the plug is removed, financial markets, especially equities, go into a tailspin, which is kind of what we’re seeing now.
Added to this is the expected sequence of interest rate hikes. Everyone is guessing about the size and speed of these changes, primarily because it’s happening many months ahead of initial predictions. While this is alarming, one key thing to remember is that central banks aren’t trying to kill the economy; if inflation is being driven by hot demand, the idea is to take their lead feet off the gas pedal, not to slam on the brakes. It’s a delicate business, and we all hope they pull it off well.
A further complication? Economies aren’t all at the same point in the cycle. The United States and Europe have lots of pent-up demand. Canada, among others, looks to be at the top of the cycle and is particularly sensitive to monetary tightening. China is a world apart as its property market is precarious, and consumers are very hesitant at the moment. In contrast, China is actually upping its monetary stimulus, which makes for an interesting monetary melée.
The plot thickens. Emerging markets will also have to absorb higher borrowing costs. Easy liquidity has caused many to increase their leverage, and this will only come out in full relief as the cost of funds increases. Let’s also remember that for those who have pushed the limits, there’ll be an added risk premium to service. Offsetting this somewhat will be a search for yield, which is likely if the stock market remains turbulent.
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That’s a long list of downsides, and hard to hear after almost two years of heightened uncertainty. Worries are being aggravated by the fact that we haven’t had to think about inflation this way for more than 30 years. There’s not a lot of corporate memory to assist in responding, and some of the coping strategies, well, they’ve gotten pretty rusty over the years. There’s a learning curve, and it’ll no doubt take time until we settle back into a more normal groove.
The bottom line?
Shifts in policy regimes are never easy. This time around, they're complicated by distortions, incorrect expectations and structural factors at play—not to mention asynchronous economic cycles. Central banks have their work cut out for them, and heavy incentive to get it right. Bringing inflation and inflationary expectations back to target may be challenging, but there’s a time-tested playbook for that. Overdoing policy measures could send us back into that disinflationary or worse, deflationary world, for which there’s a much thinner playbook. Nobody wants to go there; here’s hoping they get it right.
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