*The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.
Recently central bankers have been taking a leaf out of the politicians’ playbook, in attempting to achieve their desired outcomes through words rather than deeds. Inflation began to rise early last year as the major economies reopened, and as continued elevated demand for goods created supply bottlenecks. Sharp increases in energy prices, particularly in Europe, will inevitably push headline inflation still further above target. Although policymakers in the developed economies no longer describe the overshoot as transitory, they continue to speak and act as if inflation will fall back largely of its own accord. Investors have bought into the story. Market pricing remains consistent with steady declines in headline inflation across most major economies through this year and into the next, with policy rates of interest remaining substantially negative after adjusting for inflation. Monetary policy, in other words, is expected to remain loose. Central bank credibility is expected to do almost all the work. Words rather than deeds will continue to work their magic. But is this confidence justified?
There are certainly grounds for optimism. Medium- to long-term inflation expectations remain well anchored. They have risen, as we show in the chart below, but when the one-year ahead inflation expectations of US households last moved above 5% for a sustained period of time, five-year ahead inflation expectations of US households were also above 5%. They are currently around 3%; marginally above target, but no higher than they were through much of the 2010s, suggesting ‘fake it till you make it’ remains a credible strategy for now.
But can this state of affairs last? It is clear that households, investors, and economists alike have been getting their inflation forecasts wrong — systematically so. Since early last year, US inflation has surprised repeatedly on the upside. The longer forecasters continue to be surprised by higher-than-expected inflation, the more likely it becomes that they will change their minds about the process driving inflation. They may conclude, for example, that it has become more persistent, and medium- to long-term inflation expectations will start to rise. Such conclusions can rapidly become self-fulfilling.
This has caused Fathom Consulting to adopt, as a working assumption, the idea that inflation expectations have slipped somewhat. We model this by assuming that the degree of inflation persistence, or stickiness, has moved one quarter of the way back toward levels seen in the 1970s. This implies that inflation in our central scenario, which we label ‘Extended transitory’ and assign a 70% weight, will remain higher for longer than we had forecast back in December, and policy rates of interest will need to rise by more. In our first risk scenario, which we label ‘Back to the 70s’ and assign a 30% weight, we assume that inflation persistence has returned to levels last seen in the early days of free-floating exchange rates. In this world a material policy tightening is necessary to bring inflation, and inflation expectations, back to target – and this is likely to trigger a correction in many asset markets and a recession in many countries. We have revised up our forecast for the US federal funds rate, and see close to an evens chance that it ends the year above 2.5%.
Russia’s invasion of Ukraine underpins our second risk scenario, ‘Energy embargo’, to which we assign a 20% probability. In this scenario, Russia no longer supplies energy to most, if not all, Western democracies. With Russia accounting for some 10% of global oil supply, oil prices surge above $200 per barrel, before other producers, including the US and some OPEC members, can increase their output. With natural gas much harder to transport, European natural gas prices remain elevated for some time. Our mean path for US inflation is close to market pricing, though higher than the median forecast of economists responding to the Reuters Poll. We see around a one-in-four chance of double-digit inflation in the US later this year.
Events in Ukraine have strengthened our conviction that inflation will rise further from here, globally, and have given renewed impetus to inflation-sensitive assets. We favour exposure to silver over gold or copper, as it remains relatively undervalued. We will look for signs that liquidity has troughed, perhaps during the second half of this year, before becoming more bullish on risk assets. Nevertheless, there are some opportunities in developed Europe, with German and Italian equities appearing cheap relative to the Euro Stoxx 600. Whilst central banker’s confidence they can handle inflation without recourse to drastic action is likely justified, risks (and opportunities) remain.
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