Will the fight against inflation be easy?

In the US, consumers in the University of Michigan survey see the CPI at 3% in the 5-10 year period, while 10-year breakevens from the TIPS market are also around 3%.

That could be a fair criticism in Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, but what concerns us more is that they – and the market – think it will be easy to bring inflation back to target.

Why do central banks and investors believe that defeating inflation will be easy? The clue is in the degree of tightening that central banks and investors think is necessary. For instance, in the US, the FOMC’s median projection is that the neutral policy rate is around 2.5%, and yet the last set of projections from FOMC members suggested a peak for rates in the 2.8% region.

In other words, FOMC members feel that inflation can be defeated without rates rising much above neutral and, incidentally, at no cost in terms of rising unemployment. This is fanciful in Mr. Steve Barrow’s view. Others are the same. Even the most hawkish central bank at the moment – the Reserve Bank of New Zealand – only thinks that policy rates will have to rise to near 4% compared with its estimates of a 2-3% neutral rate. In Europe as well, central banks seem to think that they can rid their economies of inflation with fairly modest rate hikes. Financial markets might price in a bit more than central bank projections; for instance, the market puts the fed funds rate at around 3% at its peak, but that still seems low in our view.

Why do central banks seem confident about defeating inflation without substantial rate hikes, and why does the market go along with this? It relates to all the hype around longer-term inflation expectations and central bank credibility. Central banks believe that inflation expectations are still in check, even if they have risen above their target.

In the US, for instance, consumers in the University of Michigan survey see the CPI at 3% in the 5-10 year period, while 10-year breakevens from the TIPS market are also around 3%. That’s above the 2% target for PCE prices but clearly a very long way below the current inflation rate of 8.3% for the CPI.

Relatively low inflation expectations are seen by central banks as reflecting the strong anti-inflation credibility that they have earned by keeping inflation very low for the past 30-years or so. Put another way; central banks think that they are largely responsible for the low inflation that we saw before COVID-19.

Given this credibility and modest inflation expectations, banks believe that modest rate hikes will suffice to extinguish inflation; not the double-digit rates seen in many countries, including the United States and the United Kingdom, when inflation was last this high in the 1980s. It seems that the market bought this story as well. But what if 30-years of low inflation since the 1980s does not reflect the good work central banks have done but, instead, reflects the era of globalisation, which has pressed down heavily on prices?

Mr. Steve Barrow thinks this is the key to inflation; not central bank policy and central bank credibility. For a start, if central banks are so good at determining inflation, why have they most consistently undershot their targets in the past and been forced into zero-rate liquidity traps as a result. This shows that disinflationary pressure caused by globalisation has been so intense that central banks have been unable to lift it even with zero rates and QE.

All this is a bit like the story former Fed President Bernanke told about low bond yields back in 2005. He said then that policy rates and yields were low, not necessarily because the Fed was pursing a very expansionary policy, but because there was a "savings glut," mainly from Asia, that saw excess savings pushed into the US and drove real rates below desirable or appropriate levels. It is the same with globalisation, which drove inflation below desirable levels. In this case, the outflow—largely from China – was low-cost goods, not excess savings. But herein lies the rub, for now it seems that deglobalisation is in full flow.

In Mr. Steve Barrow’s opinion, if globalisation produced too much deflation for the central banks to cope with, deglobalisation is just as likely to produce more inflation than the central banks can deal with—if they only take policy rates up to neutral, or just a bit above neutral.