DM central banks, especially the US Federal Reserve (Fed), now find themselves in the unenviable position of grappling with stubborn supply-side inflation and fundamentally transformed job markets. Low unemployment rates, which are virtually back to pre-pandemic levels in major economies, may signal that the active labor pool has been structurally diminished by some combination of early retirements, reduced immigration, labor-support schemes, and/or people leaving the workforce altogether during COVID-19. Global policymakers are still trying to determine how many jobs are just “missing” and likely to return eventually, versus how many are probably never coming back (FIGURE 1).

Figure 1

Employment Rates: All Persons Aged 15-64 (%)

Source: Federal Reserve Bank of St. Louis. Chart data: December 2000–October 2021.

If central banks prematurely tighten monetary policy, they'll have even fewer tools at their disposal to adapt to fluid conditions.

A Shrinking Arsenal of Policy Tools

One medium-term implication of this shifting monetary-policy backdrop is that global central banks seem to be losing tools and ammunition from their conventional policy tool kits.

For example, forward guidance and rhetoric, along with yield-curve control (YCC) measures, are increasingly perceived as less effective and less credible than in the past and will, therefore, likely play a smaller role in central banks’ approach to navigating future economic cycles. Similarly, most central banks now recognize that quantitative easing (QE) can help combat bouts of market turmoil but is not a suitable means of generating sustainable inflation in line with policy targets. Consequently, the risk central banks now face is that if they prematurely tighten monetary policy, they will have even fewer tools at their disposal to adapt to fluid economic and market conditions.

In general, we still think the potential costs of policymakers being “early and wrong” in their actions are greater than being “late and wrong.” In addition, today’s market dynamics have resurfaced the age-old question of whether monetary policy tightening is even the best way to manage higher inflation driven by supply shortages. And could rising prices themselves lay the groundwork for a weaker cycle by blunting consumer demand for goods and services?

 

Major Central Banks Roundup

Global markets and policymakers alike are coalescing around the view that global inflation will likely remain elevated for the foreseeable future (“persistent,” not “transient” as previously hoped). However, the major DM central banks’ policy responses thus far have varied somewhat:

  • The US Fed has pushed back against calls for a more rapid tapering process for its large-scale asset purchase program, as well as against the idea of beginning to hike interest rates sooner rather than later. However, Fed Chair Jerome Powell is keeping the Fed’s policy options open with regard to both the speed of tapering and the timing of rate hikes. 
  • The Reserve Bank of Australia (RBA) has decided to abandon or at least alter its yield-curve control (YCC) target.
  • In an attempt to allay markets, the European Central Bank (ECB) recently delivered a dovish “pushback” message to markets, albeit with only moderate success to date.
  • The Bank of England (BOE) plans to embark on a rate-hiking cycle only after assessing the impact of the British government’s pandemic jobs-support plan.
  • The Bank of Japan and the Swiss National Bank have been laggards in market pricing of their rate-hiking intentions. Most other G10 banks are expected to start hiking by 2022.
As of this writing, our baseline “taper path” for the US Fed is that it will likely complete the winding down of its asset purchase program by around June 2022. The Fed has retained the option of adopting a faster pace of tapering if warranted, any further indication of which in the months ahead would validate the market’s latest forward-pricing expectations. (Currently, markets expect Fed rate hikes to begin next summer, followed by the next rate increase in November). The Fed has indicated its preference for a time gap between the end of tapering and its first rate hike, but again, flexibility is the watchword here. Should the recent acceleration in wage pressures prove to be “sticky,” for example, the Fed might have to change course.
 
 

Fiscal to the Fore?

Front-end yield-curve markets have been testing global central banks’ patience and resolve. Longer-dated sovereigns have reacted via curve flattening, suggesting a greater chance of a policy error (e.g., tightening policy too early). This has been particularly evident in the UK and US fixed-income markets. Much of the recent change in front-end pricing appears to have brought the timing of rate hikes forward as opposed to extending hiking cycles. Hence, we think fiscal policy will begin to replace monetary policy as the main influence on market direction. 

If the proposed US “Build Back Better” social safety-net bill passes (as did the physical infrastructure measure in November 2021), markets can then put a higher probability on increased government investment in the coming years. At least in the short term, this would be a potent catalyst to break the substantial US yield-curve flattening trend of recent months. Meanwhile, the European and UK fiscal pictures both point to the likelihood of high (and potentially rising) spending outlays in the period ahead—in contrast to the US, which could be in stalemate over additional government spending after the 2022 midterm elections.

Globally, growing appetites for climate-related investment needs and increased sociopolitical preferences for higher budget deficits suggest a more activist fiscal stance relative to monetary policy over the next few years. 

At this juncture, we anticipate a modestly dovish outcome for the BOE’s policy trajectory. The BOE surprised markets recently by choosing not to raise interest rates, citing job-market uncertainty and other factors. It also acknowledged that its ability to loosen policy in response to any future negative demand shocks will be hemmed in by the lower bound on rates, implying a “go-gradual” approach to normalization.

Despite the fate of the RBA’s YCC target (see above), we think the market’s hawkish policy expectations, now priced into the front end of Australia’s yield curve, are slightly overdone. We maintain a favorable bias toward select Asia-Pacific duration markets, including Australia’s.

 

Emerging Markets and the China Factor

Emerging-market (EM) central banks have taken a markedly different policy approach from that of their DM counterparts: “front-loading” rate hikes in an effort to counter inflationary pressures. This hiking cycle has been driven by a need to anchor inflation expectations and to avoid currency depreciation and related instability, which have been a headwind for many local rates but have also created pockets of value in select EM assets. We continue to believe Chinese local rates are attractive given their potential diversification benefit from historically low correlations to other sovereign-debt markets. Moreover, China’s economic and policy cycle is in a different phase than other EMs, with output now slowing and the People’s Bank of China (PBOC) likely to pursue easier monetary policy with an eye toward loosening financial conditions going forward.

On China’s economy, we think further downside growth is limited provided the PBOC’s overall policy tone remains accommodative. The two obvious wildcards that could jeopardize this usual two-step of “policy looser, growth stronger” would be a structural deterioration of home-buyer sentiment and a further acceleration in inflation. However, the apparent lack of transmission from sluggish real activity in China to softer commodity pricing is a distinguishing feature of this current cycle, as is the absence of feedthrough to growth in the rest of the Asia-Pacific region.

 

Global Inflation: The New Bogeyman?

Global inflation dynamics are undeniably changing—and most likely not for the better. At last check, inflation was already registering above its pre-pandemic peak (FIGURE 2), despite lower levels of economic growth in both EMs and DMs. This is partly due to temporary phenomena—chiefly the so-called bottlenecks associated with COVID-19-induced supply-chain disruptions—but it also seems to reflect a structural shift to persistently higher rates of global inflation henceforth. What’s driving it? A number of the key factors that dampened inflation over the past 30 years are now in reverse and have largely given way to other global forces with more long-term inflationary effects: deglobalization, localization of supply chains, labor shortages triggered by COVID-19, and evolving consumer preferences and habits, among others.

Fiscal to the Fore?

Front-end yield-curve markets have been testing global central banks’ patience and resolve. Longer-dated sovereigns have reacted via curve flattening, suggesting a greater chance of a policy error (e.g., tightening policy too early). This has been particularly evident in the UK and US fixed-income markets. Much of the recent change in front-end pricing appears to have brought the timing of rate hikes forward as opposed to extending hiking cycles. Hence, we think fiscal policy will begin to replace monetary policy as the main influence on market direction. 

If the proposed US “Build Back Better” social safety-net bill passes (as did the physical infrastructure measure in November 2021), markets can then put a higher probability on increased government investment in the coming years. At least in the short term, this would be a potent catalyst to break the substantial US yield-curve flattening trend of recent months. Meanwhile, the European and UK fiscal pictures both point to the likelihood of high (and potentially rising) spending outlays in the period ahead—in contrast to the US, which could be in stalemate over additional government spending after the 2022 midterm elections.

Globally, growing appetites for climate-related investment needs and increased sociopolitical preferences for higher budget deficits suggest a more activist fiscal stance relative to monetary policy over the next few years. 

Figure 2

Inflation Is Already Running Well Above Its Pre-Pandemic Peak

Source: Bloomberg. Data covers the period from 1/31/10 to 10/31/21.

We think the most likely endgame for the current global cycle will be one of reflation rather than stagflation.

The next six months could be characterized by rocky, uneven growth patches. Nevertheless, at a high level, we still think the most likely endgame for the global cycle that is now underway should be one of reflation rather than the much-feared “stagflation” scenario, as many consumers spend down the savings they accumulated during the pandemic, corporations increase capital expenditures (capex), and government policy—particularly fiscal—remains supportive. We believe the greater risk is that of recession rather than stagflation—if, for example: inflation squeezed real wages and turned the cycle over; global COVID-19 cases resurged; central bankers prematurely tightened policy, and/or China’s slowdown worsened. 

In any event, what’s clear is that rising global inflation is leading central bankers worldwide to reassess the risk/reward trade-off of letting their economies run hot for too long. Accordingly, investors should no longer assume that flagging economic growth will always result in ever-more policy-driven liquidity courtesy of central banks. With that in mind, a pivotal (and as-yet unanswered) macro question is whether labor-market dynamics have changed sufficiently to allow workers to be compensated for higher inflation through higher wages. If so, then inflation is likely to have legs, and monetary policy is likely to tighten sooner and by more than markets expect. If not, then the cycle would likely sour, as consumers’ purchasing power gets increasingly pinched. 

 

Key Takeaways

  • Global markets are less likely to perceive monetary policymakers as reliable forecasters or drivers of economies and business cycles. DM central banks may struggle to achieve dovish, market-friendly outcomes relative to the market’s more hawkish expectations these days.
  • Rather than extending rate-hiking cycles, markets are “pulling forward” the timing of rate hikes amid worries over rising inflation and slowing economic growth, which have eroded markets’ confidence in the longer-term macro outlook. 
  • Global trade wars and the COVID-19 pandemic have reshaped the nature of inflation risk, with secular themes of deglobalization and localization of supply chains incenting firms to hold higher amounts of inventory going forward.
  • Central bankers face a delicate balancing act: Is monetary policy tightening supposed to help rein in higher consumer prices, OR will accelerating inflation itself set the stage for a weaker cycle? DM and EM policy responses to this dilemma have differed. 
  • The inexorable trend toward decarbonization will likely temper global growth to some degree, at least until more countries can map out viable longer-term energy-transition plans. 
  • We currently favor underweight duration biases in the US, the UK, and Europe, versus moderate overweight biases in Asia-Pacific, including South Korea, Australia, and China. 

US Inflation, Productivity, and Wages

In the US, our current bias is toward higher unit-labor costs and more enduring inflation relative to the Fed’s and market’s expectations. Pipeline-cost pressures, supply bottlenecks, and retail-price projections would suggest that goods inflation stays elevated before waning over the next 12 months. At the same time, we think core-services inflation, which is more sensitive to the domestic-output gap and labor markets, will start to pick up. If our leads are right, all of which imply upside risks to the Fed’s 2022 inflation forecasts, we suspect the Fed would start to more seriously question the dubious “transitory narrative,” especially given some improvement in the labor market. We will be closely monitoring the details of capex and of prospective fiscal policy for anything that might challenge our thinking. 

The Fed seems pretty upbeat about US productivity growth rising in the context of potentially higher labor-market participation rates. This attitude underpins the Fed’s belief that: 1) longer-term inflation will likely settle back around 2.0% over time; and 2) there remains excess capacity in the domestic labor market. While recent productivity, wage, and inflation data don’t necessarily support this, we think the Fed’s optimism is still justified given today’s labor shortages, US demographics, and other factors. It would likely take time for the Fed to meaningfully revise its view on structural productivity trends. 

 

Commodity Prices and Decarbonization

Commodity prices will be critical to both the global and US inflation outlooks. A potential change in OPEC+’s reaction function (including a marginally greater tolerance for higher oil prices) and/or US shale discipline preventing a proportional increase in US oil production could continue to push oil prices upward in 2022. 

Broadly speaking, ongoing decarbonization will likely restrain global growth to some degree, at least until countries can map out viable longer-term energy-transition plans, including a bridge of sorts (i.e., natural gas) between fossil fuels and renewable energy. In the interim, commodity-price pressures are showing signs of impacting the economic reopening-linked demand and growth recovery. But the US consumer has rarely been healthier, with the low-wage cohort in particular stepping up its spending in an environment of significant labor shortages and widely understated wage gains. The US economy seems better placed to weather the latest energy storm than DM energy importers such as  Japan, the UK, and the eurozone. In addition, US trade exposure to China looks negligible when compared to that of Australia, New Zealand, and Japan. 

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Key Takeaways

  • Global markets are less likely to perceive monetary policymakers as reliable forecasters or drivers of economies and business cycles. DM central banks may struggle to achieve dovish, market-friendly outcomes relative to the market’s more hawkish expectations these days.
  • Rather than extending rate-hiking cycles, markets are “pulling forward” the timing of rate hikes amid worries over rising inflation and slowing economic growth, which have eroded markets’ confidence in the longer-term macro outlook. 
  • Global trade wars and the COVID-19 pandemic have reshaped the nature of inflation risk, with secular themes of deglobalization and localization of supply chains incenting firms to hold higher amounts of inventory going forward.
  • Central bankers face a delicate balancing act: Is monetary policy tightening supposed to help rein in higher consumer prices, OR will accelerating inflation itself set the stage for a weaker cycle? DM and EM policy responses to this dilemma have differed. 
  • The inexorable trend toward decarbonization will likely temper global growth to some degree, at least until more countries can map out viable longer-term energy-transition plans. 
  • We currently favor underweight duration biases in the US, the UK, and Europe, versus moderate overweight biases in Asia-Pacific, including South Korea, Australia, and China. 

For more information on fixed-income opportunities, contact your Hartford Funds representative.