Uncertainty over how long it will take to tame inflation has kept the US Federal Reserve (Fed) and European Central Bank (ECB) in policy tightening mode. That could leave equities struggling as markets adjust their views on the likely paths of central bank policy and bond yields move higher in the short term. By contrast, in Asia, the current cycle is more about normalising monetary policy than raising rates to fight inflation. GDP growth and financial markets in the region may thus outperform those in the West.
Since the Fed started tightening its monetary policy last year, sectors sensitive to interest-rate movements have responded in predictable fashion: Housing starts and sales have fallen on rising mortgage rates, while consumer spending on durable goods and business investment have faltered in the face of higher financing rates.
As the US economy normalised after the Covid shock, consumer demand – especially for services – recovered, pushing up prices, and the post-pandemic catch-up in hiring boosted job gains. Both inflation and labour demand have been sticky.
Persistent hiring resulted in unit labour costs surging by 6.6% year-on-year (YoY) for the full-year 2022 compared to only 2.1% in 2021 (see Exhibit 1), while labour productivity was revised down to -2.0% YoY from -1.5%. It is no surprise then that the Fed worries about inflation expectations becoming unanchored.
Fed Chair Jerome Powell reiterated his hawkish anti-inflation message in his recent congressional speech (7 March), saying that strong demand would likely warrant higher interest rates than previously expected, thus keeping open the possibility that rate increases could speed up again.
Across the Atlantic, the ECB’s policy tightening does not seem to have done much to cool demand or inflation in the eurozone either. Core inflation has remained high and sticky, rising by 5.6% YoY in February from 5.3% in January, even as the headline rate eased to 8.5% from 8.6% in January.
The fact that core inflation is proving stubborn – well above the ECB’s 2% target – both puzzles and worries the ECB. It is puzzling because as the eurozone economy recovers from the worst of last year’s energy crisis, lower oil and gas prices should pass through to core goods and services inflation. Except that it hasn’t. Such persistently high core inflation is also worrisome as it increases the risk of a wage-price spiral given the still-strong eurozone labour market.
Financial markets have thus been repricing to account for a shift in central banks’ policy rate paths. In the US, the fed funds terminal rate is now expected to surpass 5%. The ECB’s peak rate for this cycle is expected to hit 4.0%. And in Japan, the 10-year government bond yield is testing the Bank of Japan’s ‘yield curve control’ upper bound of 0.5%, reflecting market expectations of higher Japanese interest rates.
Inflation complexity
The outlook for inflation remains uncertain for this year and into 2024.
To start with the US, one scenario is that inflation continues to trend down towards the Fed’s 2% target without damaging economic growth. That would require both labour market and wage growth to slow. Recent macroeconomic data points to a moderate probability of perhaps 25% for this outcome.
Another possibility is that inflation remains sticky at around 3-4% in the coming months. This would force the Fed to choose between crushing the economy to force inflation down to its target, or waiting to see if inflation simply eases enough on its own. Mr. Powell’s latest warning suggests that the Fed would sacrifice growth in order to bring inflation down quickly. The probability of this outcome could be as high as 50%.
Lastly, (core) prices may rise again later this year and into 2024, perhaps to 5%, as the combined strength of the US labour market and the re-opened Chinese economy drive up services and goods inflation. This outcome may have a probability of 25%.
Putting these scenarios together gives an expected inflation rate of 3.25-3.75%, which would mean that the Fed and the other major central banks are not yet done with raising interest rates.
Crucially, this is not just about a range of scenarios. It is also about probabilities shifting over a short period.
The resulting uncertainty shows up in the short-term outlook for economic activity, prices and monetary policy. It also applies to long-term shifts in structural dynamics such as the clean energy transition, shifts in global supply chain patterns, and the rise of regionalisation (led by China) clashing with de-globalisation (led by the US).
In the absence of recessionary forces taming inflation, market expectations of Fed policy will continue to drive the outlook. The Fed’s increasingly hawkish views will likely cloud both stock and bond valuations in the short term.
The China factor
Adding to the sea of uncertainty is China’s recovery. Recent data shows there is already good momentum. February’s PMIs were at multi-year highs, city commuter passenger volumes have rebounded to pre-Covid levels, and property market transactions are recovering to pre-Covid levels from a deep contraction.
Some observers may wonder whether China’s recovery will add to global inflation and thus increase the pressure on developed market central banks to raise interest rates.
This does not need to be the case; China’s inflation rate is expected to be far below that of the developed world (see Exhibit 2). However, the China factor looks set to remain a catalyst for volatility in global markets.
What is clear to us is that China’s monetary policy is bucking the rate-rise trend in the West. Beijing’s policy easing is part of coordinated fiscal and regulatory shifts designed to revive GDP growth this year and next.
Asia should benefit from China’s recovery. With inflation much less of a problem in the East than in the West, the stance of the region’s monetary policy is more about normalisation than tightening.
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