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Striking a Balance: Risks to Growth Require "Light-Touch" Policy on Inflation
BY :ED PERKS
JANUARY 05, 2022
The global economic shutdown we experienced in mid-2020 was unique in recent history for its ability to disrupt the flow of goods, services, and labor around the world. Since then, regionalized shutdowns in response to the resurgence of Covid-19 infections have been implemented periodically, often with very little warning.
Global supply chains have been badly affected by this uncertainty, struggling to cope with the rapid recovery in demand for goods during 2021. This outsized demand is linked with healthy consumer and business balance sheets, helped by generous monetary and fiscal policies.
As a result, we have seen inflation rise sharply in both developed and emerging markets (EMs), causing concern for policymakers, companies, and investors. US core inflation (less energy and food) was running at 4.9 percent on an annualized basis in November, well above the US Federal Reserve’s (Fed’s) stated long-term target.
Base effects have heightened this figure, but it has been elevated for the past eight months. There was a similar dynamic in the United Kingdom, Canada, the eurozone, and a range of EM countries.
Normally, figures like these would be enough to trigger concerted monetary policy action designed to cool the economy. Still, major central banks have, so far, taken a more considered approach, influenced by upheaval related to the Ccovid-19 pandemic.
Taming inflation is the primary aim, but policymakers must frame their decisions in the context of waning growth and recovering labor markets, which could be further affected by the arrival of a new coronavirus variant.
Against this background, we believe global inflation will likely keep rising through year-end 2021, as demand remains high throughout the holiday period, and ongoing disruption to supply chains maintains pressure on input and output prices.
However, we expect inflation to peak before the halfway point of 2022 as economic growth normalizes, demand eases off, and supply issues begin to dissipate. There is already evidence of this in lower backlogs of work and a gradual increase in finished goods inventories. The ongoing transition to a services-led economy should also minimize the effect of cross-border supply-chain pressures.
Although we think inflation will shortly pass its peak, we do not expect it to return to normal levels until the end of 2022. Furthermore, inflation may stabilize at a higher level than we experienced in a pre-Covid-19 world where low inflation was taken for granted.
In our view, a range between 2.0–2.5 percent is more likely for several reasons, including wage growth and a more relaxed approach to inflation policy. Wages are unlikely to rise uncontrollably, but we could see persistent upward pressure on wages across all sectors if labor participation rates continue to lag. Higher productivity levels may act to cool unit labor costs, but inflation will likely remain slightly more elevated than pre-pandemic levels for some time.
While the normalization of inflation next year is our base-case prediction, there is the possibility that certain risks materialize in concert and act to keep inflation high throughout 2022 and into 2023. In our view, this scenario is less likely, but it must be acknowledged given the effect this could have on financial markets.
Importantly, households have benefited from the pandemic stimulus, while restrictions on movement and travel have helped boost savings and spending power. This could lead to persistent above-trend demand, which we believe is the major contributor to inflation. Unforeseen supply issues related to labor shortages, global production, fresh Covid-19 lockdowns, and energy shortages also can further exacerbate inflation.
Elsewhere, upcoming fiscal stimulus measures, such as US President Biden’s US$1 trillion infrastructure package, may inadvertently add inflationary pressures while supporting economic growth through major new construction projects.
Sustained recovery depends on a cautious approach from policymakers
We expect major central banks to take somewhat different approaches to monetary policy during 2022 while sticking to their carefully communicated plans for normalization. The Bank of Japan and the European Central Bank have been sanguine in their approach. Still, the Fed, alongside the Bank of Canada, among others, has been more aggressive, initializing asset purchase tapering in advance of expected interest rate rises.
The Fed’s asset purchase tapering program, begun in November, should be completed early in 2022, while the federal funds rate will also have risen from a very low level by the end of 2022 under current projections.
This kind of steady progress toward normalization should allow inflation to dissipate naturally, in our view, without the need for heavy-handed policy intervention. Further moves to control inflation could precipitate a drawdown in equity markets, given current high valuations and growth that remains above trend but is slowing. The latest Fed projections show US real gross domestic product was already falling from a post-pandemic spike in 2021.
There is also a risk that reducing liquidity too quickly could slow growth to critical levels, weakening business confidence and corporate investment to such an extent that central banks are forced into a U-turn to reinflate economies and markets. Premature tightening might also undermine investor and consumer sentiment, making any retrospective loosening less effective.
In the United States, Fed Chairman Jerome Powell’s nomination to serve a second term creates welcome continuity for financial markets and should reduce fears around monetary policy stability. However, a reconfiguration of the Fed board might increase the chances of a more hawkish approach, dependent on the persistence of inflation and the influence of political factors such as fiscal policy.
Implications for multi-asset investment strategy
We continue to favor equities over bonds into 2022, as corporate earnings generally remain healthy, indicating that businesses can preserve profitability by passing rising input costs on to customers. This has been facilitated by high demand and demonstrates how certain inflation is not necessarily bad for equities.
If margins remain robust throughout 2022, equity markets could strengthen further as inflation normalizes. On the other hand, elevated valuations relative to historic levels, could come under pressure if high expectations for earnings performance are not met.
The ongoing threat from new variants of Covid-19 is one risk that could undoubtedly suppress earnings, particularly if governments choose to act cautiously. Lockdowns and travel restrictions of greater or lesser severity will all serve to disrupt business activity and affect consumer sentiment.
One interesting consideration is how inflation has impacted industry sectors differently, notably around wage growth, in an environment where increasing wages reduce earnings per share.
We have observed that rising wages are having a greater impact on companies with lower-paid workforces such as transportation and food retail, so we will be factoring this data into our equity investment decisions during 2022.
Elsewhere, the US Treasury yield curve is no longer steepening, which is a good indicator that the bond market is pricing at a peak for inflation. We believe this confirms our preference for equities. Given the risks attached to persistent inflation, we will maintain most of our fixed-income holdings in short-duration bonds with lower interest-rate sensitivity.
Such a stance signifies meaningful yield is difficult to achieve. However, that can be addressed, in our view, by investing in high-yield corporate bonds which offer significant carry-over US Treasuries with an attractive risk-return profile. Cash and short-term US Treasuries also play an important role in our investment strategy, offering protection against the elevated volatility expected as a product of monetary policy normalization.
Ed Perks is the chief investment officer at Franklin Templeton Investment Solutions.