Key points
Well, it's certainly been an eventful start to 2022. To slay inflation—the ultimate villain—the major central banks have now shifted into full‑blown tightening mode. Predictably, interest rates have reacted by selling off, and risk markets are on the back foot.
In the early stages of monetary tightening cycles, risk markets usually struggle at first before finding their feet. Below, I explore why this tightening cycle looks different and why I believe it will turn out to be an extraordinarily bumpy one for risk assets. Put simply: To bring inflation to its knees, central banks will need to keep risk markets off balance.
When Temporary Becomes Permanent
Only a few months ago, U.S. Federal Reserve Chair Jerome Powell described the inflation spike as "temporary" (in central bank lingo, the word temporary means a shock that does not require a monetary policy response). By the time of the January Federal Open Market Committee (FOMC) meeting, however, Powell had clearly changed his mind. With growth expected to run above potential and the labor market expected to tighten further, he made it clear that he believes the surge in inflation will exhibit some very "persistent" features.
Persistent inflation requires a policy response—in which case, Powell and his colleagues at the Fed have a real challenge on their hands. Monetary policy must be tightened to reduce the demand for labor—and we're not talking about a "benign" tightening to anchor inflation expectations or preemptively slow the economy before it hits full capacity. No, the economy is already operating at full capacity, wage inflation is real and persistent, and the central bank is behind the curve. Seen from this angle, the Fed finds itself in a situation that it has not been in for more than a decade.
In an ideal world, the Fed could tighten monetary policy and all risk markets would continue to trade well while the economy slows. But that isn't the world we live in. In reality, the Fed must accept either a strain on the markets or an economy that continues to grow above potential. At the January press conference, Powell made it clear that it would be the former.
Financial conditions are not under direct control of the Fed, but the policy rate is a powerful lever and, if used persistently, it will move financial conditions in the direction the Fed desires. The exact nature of the tightening of financial conditions is the result of a complex interaction between growth and risk sentiment. When growth is strong, risk assets such as equities, credit, and foreign exchange tend to trade well. To drive financial conditions tighter against a backdrop of strong growth, the Fed must deliver a robust salvo of interest rate hikes. Although equity and credit markets are likely to remain resilient in such a scenario, the bond market will crack as the policy rate is driven to increasingly high levels, and eventually the dollar will strengthen.
This post was funded by T. Rowe Price
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