How do adverse supply shocks impact monetary policy?

We have seen two such adverse supply shocks in short order with the pandemic and Russia’s invasion of Ukraine. 

Adverse supply shocks create weaker growth and higher prices. We have seen two such shocks in short order with the pandemic and Russia’s invasion of Ukraine. If advanced countries can avoid stagflation, it will be a minor miracle. Soft landings are rare when policymakers lift rates, and the chances of this landing being soft for both economies and financial assets seem slim. This is due to the unique nature of the situation that policymakers are facing. Not since the1970s have policymakers faced such inflation borne of supply shocks.

Usually, when the source of inflationary pressure comes from the demand side, central banks can use a well-worn playbook to hike rates and reduce demand to what is largely a constant level of global supply of goods and services. But, at the moment, nobody knows just how much supply has been depleted by the pandemic and the conflict in Ukraine. The plethora of new measures of supply chain pressures doesn’t bode well for the future.

As a result, even if higher policy rates cut demand significantly, it might still be the case that these lower demand levels sit way in excess of reduced supply, and hence inflation will not fall back to target, as central banks seem to be assuming, over the next few years. Mr. Steve Barrow, Head of Standard Bank G10 Strategy, leans to the view that inflation will prove more stubborn than most expect. The IMF sees average CPI inflation in the advanced countries falling from 5.7% this year to 2.5% in 2023, but he regards both forecasts as too low.

The corollary of this is that it may take a significant recession to rid advanced countries of the inflation bogeyman from the demand side. But we have to question whether they will do this, especially if the hope remains that supply-chain pressure will ease and so bear down on inflation. The problem in going too soft on policy tightening is that, even as supply pressures ease and help reduce inflation, this long period of high price growth will embed itself in longer-term inflation expectations.

As a result, high inflation may take on a life of its own even as supply chains unblock. Up to now, many central banks, led by the Fed, have been patient, hoping that supply chains will ease. But that’s not happened, and now they have to correct their mistake by tightening policy quickly. Others have taken the lead here, like the Reserve Bank of New Zealand and the Bank of Canada, but now it is the Fed’s duty to catch up and hope that lifting the Fed funds rate by a likely 200-bps, or more, this year does not unnerve domestic and global financial markets, so compounding the recession risk. It is, of course, very possible that financial markets remain sanguine – but we think it unlikely.

For some time now, Mr. Steve Barrow has held the view that asset prices, meaning stock and bond prices, will fall in tandem, and he sees no reason to change this view now. In time, government bonds will become a buy again, but that’s not now, while corporate bonds appear unattractive to us over both the short- and the medium term. “Although we’d describe the current economic and financial market position as extremely uncertain and hence dangerous for investors, the currency markets have been relatively calm”, Mr. Steve Barrow said.

The dollar’s narrow trade-weighted index has been stable in recent years, compared to previous years. Mr. Steve Barrow puts this down to two main factors.

The first is that these adverse supply shocks, particularly the pandemic, are symmetric. All countries have been adversely impacted and hence the justification for exchange rate variation is absent. The Russia/Ukraine war is different as it is more of a terms of trade shock, with losers (commodityimporting countries) and winners (commodity exporters).

The second reason for dollar stability is that the Fed is better able to supply dollar liquidity in times of global tension through FX swaps and repos. This has diminished the dollar shortage problem that used to arise in the past. Looking ahead, there seems little reason for the dollar to surge; in fact, its overvaluation plus the fact that a lot of Fed tightening is already priced into the market, imply that the longer-term trend is lower.