News in Charts: Credibility stretched?

Markets were doubly rattled in late November, first by the emergence of the apparently more transmissible Omicron variant of COVID-19, and second by a suggestion that the Fed taper may need to proceed more rapidly than had been assumed, perhaps opening the door to an increase in the US policy rate as early as March. Before this news, the S&P 500 had been 40% above its pre-COVID peak and 110% above its early-pandemic lows. A reminder that the virus has the potential to mutate, combined with the increased likelihood that we are entering a period of tighter liquidity, has led Fathom to become more pessimistic about the equity outlook. We now see an evens chance that the strong upward momentum in the S&P 500 has come to an end, with this index, and other major benchmarks, no more likely to rise over the first few quarters of our forecast than to fall.

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IN HOUSE

Based on experience of the Alpha variant late last year, we expect the impact of Omicron on global activity will be limited. If renewed lockdowns were put in place, it is almost inevitable they would be combined with additional fiscal support, potentially creating further supply bottlenecks, and putting further upward pressure on inflation, which brings us to investors’ second cause for concern.

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Inflation has surprised on the upside across the major economies, and notably in the US, where it has reached 6.8%. The source of the initial global shock to inflation was a substantial shift in the composition of household expenditure away from consumption of services towards consumption of goods, reversing a trend that had been in place for decades. With producers unable to respond immediately to this dramatic switch in demand, the macroeconomic consequences look much like those of a negative supply shock. Output is lower than otherwise, and prices are higher. With consumption of many types of services prohibited during periods of lockdown, a step-increase in the goods share of consumption was an inevitable consequence of the pandemic. There are signs that the goods share is returning to more normal levels in some countries, notably France, but in the US it remains elevated.

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A return to a more normal mix of household spending should lessen some of the upward pressure on inflation. There are already signs that shipping costs, for example, have peaked and are starting to fall. Nevertheless, business surveys suggest price pressures remain elevated, not just in manufacturing but elsewhere.

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Ultimately, whether the consequences of the initial shock to inflation prove to be transitory or whether they prove to be sustained will depend on the expectations of firms and workers. When inflation is seen as under control, workers will accept small fluctuations in actual inflation around the target without it affecting their desired remuneration because they believe, likely as not, inflation will be back at target next year. Some years workers win, and some years they lose. In this world, it is as if inflation expectations do not matter. But there is a risk that we are not in that world anymore. Headline inflation in the US reached 6.8% in November, and few believe it will be back at the target next year. Evidence from the University of Michigan survey suggests that US households are willing to tolerate inflation in the range 0%-3% without it affecting their beliefs about future inflation. Beyond that range, which is where we are now, inflation expectations rise broadly in line with actual inflation.

IN HOUSE

There is material uncertainty about the outlook for monetary policy, globally. At Fathom we cannot recall a time, in our collective memory, when it has been higher. This is reflected in the width of our fan chart for the Fed funds rate. Any anxiety currently felt by those with exposure to interest rate-sensitive financial assets is justified. Those responsible for setting monetary policy continue to assume, or perhaps hope, that their hard-won credibility will do pretty much all of the work when it comes to getting inflation back under control. They may be right. We think there is about an evens chance that they are. In our ‘transitory’ scenario inflation is now close to its peak. It falls back rapidly towards target through next year, with minimal intervention required from policymakers. This is precisely what is priced in, as our chart shows. But the risk is that firms and workers begin to expect a more sustained pickup in inflation, which affects their wage- and price-setting behaviour and becomes self-fulfilling. In that world, interest-rate setters would have their work cut out. They would need to take tough decisions. Bringing inflation back to target when expectations of higher inflation have become embedded, and the inflation genie is out of the bottle, might require interest rates increases of several hundred basis points. Recent Fathom analysis of the drivers of consumer confidence suggests to us that the public, in both Europe and the US, has a strong dislike of inflation, even if higher prices are matched by higher wages. Nevertheless, our judgement remains, for now, that if the pickup in inflation becomes sustained, to which we attach a 50% weight, policymakers are more likely to ‘roll with it’ and accept a prolonged overshoot of the current 2% target, perhaps even shifting the target itself, than to ‘deal with it’ and tighten policy aggressively.

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