“Inflation will be harder to bring down than markets think” (The Economist, 18 February 2023)

“Inflation will be harder to bring down than markets think”

The Economist, Leaders – 18 February 2023

Financial markets have recently been buoyed by investors' optimism that inflation will fall away without much fuss and that resulting interest rate cuts towards the end of 2023 will help major economies avoid a recession. Investors are pricing stocks for a Goldilocks economy where companies' profits grow healthily while the cost of capital falls. The S&P 500 index has risen by nearly 8% since the start of the year, and European stocks have risen even more. But according to The Economist, such an optimistic outlook is misguided because the world's battle with inflation is far from over, and markets could be in for a nasty correction.

Although recent consumer-price figures showed more subdued inflation over the three months to January than at any time since the start of 2021, fluctuations in headline inflation often mask the underlying trend. America's "core" prices, which exclude volatile food and energy, grew at an annualised pace of 4.6% over the past three months and have started gently accelerating. The services sector, more exposed to labour costs, has become the main source of inflation. Six of the G7 group of big rich countries enjoy an unemployment rate at or close to the lowest seen this century, making it hard to see how underlying inflation can dissipate with such tight labour markets.

Market turbulence thus seems likely. Bond investors have begun pricing a scenario under which central banks won’t cut interest rates but will instead keep them high. It is conceivable that rates stay high without seriously denting the economy, while inflation continues to fall. Yet persistently higher rates would inflict losses on bond investors, and continuing high risk-free returns would make it harder to justify stocks trading at a large multiple of their earnings. It is far more likely that high rates will hurt the economy, and history is full of examples of investors wrongly anticipating strong growth towards the end of a bout of monetary tightening, only for a downturn to strike.

Central banks faced with a stubborn inflation problem might not have the stomach to tolerate a recession and might allow inflation to run a little above their targets. In the short run, that would bring an economic sugar rush. It might also bring benefits in the longer run: eventually, interest rates would settle higher on account of higher inflation, keeping them safely away from zero and giving central banks more monetary ammunition during the next recession. However, managing such a regime shift without wreaking havoc would be an enormous task for central banks, as they have spent the past year emphasizing their commitment to their current targets, often set by lawmakers.

Read the full article on The Economist website for more information (subscribers only).‍