Rebalancing consumption and investment

Central banks will be able to equalise supply and demand so that price pressures dissipate.

Central banks around the world have been focussed full-square on reducing consumer demand to what they believe to be the new – compromised – level of supply as dictated by adverse shocks such as the pandemic and conflict in Ukraine. This need for a slowdown in consumer demand is cyclical, but it is also structural as the world needs stronger investment to tackle these supply constraints over the long haul. The problem is that cyclical and structural needs could clash.

Understandably, central banks and governments are focussed primarily on what’s immediately ahead, particularly governments that worry about being re-elected. Right now, this means constraining demand, particularly consumer demand, in order to bring some balance between demand and the lower supply that’s come about because of a number of adverse shocks. Some of these shocks themselves act as natural demand depressants, such as the surge in energy prices bought about by the conflict in Ukraine.

However, central banks have had to go above and beyond this to try to bring demand down further even though many countries are staring recession full in the face. Given time central banks will be able to equalise supply and demand so that price pressures dissipate. It is not easy to say whether this is close at hand or still some way off but it is clear that central banks will continue to tighten until this has been achieved. Not long after that the financial markets will assume that it’s job done for the central banks and they can start to ease again.

If we look at the US, for instance, the market is priced for the Fed to begin easing policy before the end of 2023. But is this correct? For a start, there seems to be an unwritten assumption in here that supply will steadily return so that once inflation is eliminated, central banks will be able to lower rates and let demand rise back up without any cost in terms of rising inflation. This might be an unrealistic assumption.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said it is not at all clear that better supply/demand balance can be achieved over the long haul via a bout of weaker consumer demand– and recessions – now. What’s crucial is that investment improves for this is required to address the supply challenges the world faces. It is certainly important in terms of labour challenges in advanced nations. Tight labour markets look as if they may persist, even in the midst of looming recessions, and that’s going to mean that more growth is going to have to come from improved productivity; something that’s only likely with higher investment.

Much stronger investment is also going to be required to move away from the use of fossil fuels and to deal with the impact of climate change. But higher interest rates and, in some cases, windfall taxes on energy companies, are the sorts of things that could constrain much-needed investment going ahead.

In other words, the rate hikes from central banks designed to create the cyclical decline in consumer demand, could compromise the structural requirement for stronger investment that’s needed to ease supply chain pressures. Of course, investment is about much more than the level of interest rates and we should not forget that while interest rates have been rising in nominal terms, they are still very low in real terms.

Nonetheless, Mr. Steve Barrow is not hopeful that there will be a sufficient and long-term rebalancing of consumption and investment that facilitates the necessary supply-side improvements that extinguish inflation completely. “We think that central banks will fall short of sustainably meeting their inflation objectives, which are mostly set at the 2% level. We do still feel that many central banks will want to start easing policy as inflation falls; hence we see the Fed starting to cut rates in the first half of 2024. But we do have doubts that the next easing cycle will be as substantial as many in the market might be hoping. Supply strains will keep inflation quite elevated into the long haul even if there is a temporary and cyclical overshoot on the downside first”, said Mr. Steve Barrow.