The Pain Trade- How Aggressive Will The Fed Be On Inflation

In the film Mutiny on the Bounty, Captain Bligh declares to his militant crew that ‘beatings will continue till morale improves’. This tactic doesn’t end well for Bligh, though he eventually makes it to safety. Yet, the notion of ‘beating till the morale improves’ is perhaps better applied to financial markets. As a very simple rule, in the case of underlying imbalances or economic stress, they (market prices) will often extend to levels that cause pain.

The past number of weeks have been an excellent case in point. Extreme moves in commodity prices for instance have caused hardship, political turmoil, and increasingly, unrest (Sri Lanka for instance). This introduces several levels of socio-political complexity into the debate on markets. The value of free moving prices (as opposed to those under the spell of quantitative easing) is that they send signals about the health of the world economy and its moving parts. Policy makers should pay attention to these and map their implications (will we have fuel shortages and power cuts this winter?).

Food crisis

There is also a countervailing argument that extreme price moves that harm people’s livelihoods should be curbed. To an extent that is hard to do on a consistent basis and is ultimately the role of central banks at a broad level – most of whom have failed their mandates. We should expect that for the rest of this year, many nervous governments will deplete their fiscal capital.

One market signal worth paying attention to is the dollar, whose recent strength has manifest itself as yen weakness, and is now driving the euro down towards parity with the dollar. A range of emerging market currencies – Chilean peso for instance – have also sold off. At one level these moves can be interpreted as individual regional stresses (German trade weakness notably) but a more comprehensive view is that dollar strength is signaling demand by investors for safe(r) assets and money. Should dollar strength persist, it should be a cause for concern, as a signal of what is occurring in portfolios, and for the spillover effects that could produce a mini ‘dollar’ crisis (see this ‘our dollar, your problem’ note from David Skilling).

With the half year point now here and having been through multiple sell-offs (commodities being the latest), the pain trade is still likely with us, but could be expressed in two very distinct ‘pain’ channels, both of which depend on the reaction function of central bankers and will have marked socio-economic effects in years ahead.

Rates to 5%?

It is possible that, mindful of the drop in commodity prices and especially the more politically sensitive aspects of these (gasoline prices) and the implications of this for headline inflation, central bankers begin to soften their message on ‘killing off’ inflation. In particular, it is not yet clear that central bankers have the levels of monetary sadism required to stomach the collateral economic and political damage associated with thoroughly suppressing inflation. In that respect they might adopt a ‘living with higher prices, avoiding recession’ stance.

While to a certain extent this is priced into interest rate markets (they expect the Fed to cut rates through 2023 and mortgage rates are dropping from a high level) an ‘inflation permissive’ message from central bankers would set in train a new market and economic regime.

Bond markets would weaken, commodities rally as an inflation hedge, as would the stocks of companies with pricing power. It may also be that the equity value of companies with large debt levels would rise, given the real effect of high inflation/steady rates on debt. Economically however, the prospect of a higher trend level of inflation could lead to upward pressure on wages, at least for those who have bargaining power, and in broad terms would lead to a relative transfer of wealth from asset poor lower income workers to wealthier, higher earners.

Sado-monetarism

Another monetary piste down which the Federal Reserve and other central banks can travel is to persist in the fight to flatten inflation (for the moment the most likely scenario). This bid to reinforce their credibility would occur in the face of weakening economic activity (the Fed has unusually been raising interest rates in the face of record lows in consumer confidence), where they would continue to ratchet rates upwards until inflation overshot to the downside (early next year).

The effect of this in wealth terms would be more vicious deflation in asset values, most notably property prices in the developed world (Australia, Canada, the US are vulnerable). The economic effect would entail a sharp recession, and a large negative wealth effect on the wealthier classes. Politically, a number of governments would, simply by association bear the downside (though Biden’s approval ratings are already strongly negatively correlated with inflation) and we may well likely see a sharp deterioration in relations between politicians and central bankers.

Many central bankers would understandably wish that inflation would melt away, and to a large extent supply chain blockages and commodity price rises are ebbing. There is still the risk that service price inflation and rents push higher, and that these rises prove sticky and hard to reverse. Resolving these pressures will be complex and will involve a coordinated effort between governments and central banks to best distribute the economic ‘pain’, and at a time of great change, maintain social cohesion (mindful of the political consequences of the 2009 global financial crisis).