January 21, 2022 | 12:57
The Tide is High
Markets are absorbing the reality that the Fed means business. And taking the toughest hit are the corners of the market flying closest to the sun, with the Nasdaq down over 10% in three weeks and diving below its 200-day moving average. The fact that U.S. inflation is at a near four-decade high, and apparently not quite yet at its peak, means that the Fed will not be able to quickly reverse the policy course if the waters get rougher. And note that this squall has formed when the Fed is still in QE mode, with rate hikes only beckoning (by March), and QT still a distant prospect (perhaps late this year). The fade in equities also pulled down yields, with 10-year Treasuries ending the week a tad lower at around 1.75%, after hitting a pandemic peak of 1.90% on Tuesday. The shudders even spread to oil, ending at close to $85, and halting a seemingly one-way trip north.
At the heart of the market jitters is the relentless rise of inflation. While there were no major new developments on that front in the U.S. this week, there were plenty of warning flags globally. Headline inflation rates hit new multi-decade highs in both Britain (5.4%) and Canada (4.8%) in December, and were confirmed at such in the Euro Area (5.0%). Even Japan (0.8%) saw its highest inflation rate in two years, due to rising food and energy costs.
The broad-based upswing of inflation is certainly capturing the public imagination in many nations, potentially shifting expectations on a more lasting basis, perhaps the last thing central banks want to see at this stage. Two separate surveys in Canada offered a hint this week on how these expectations are morphing: 1) The CFIB reports that small businesses are planning on hiking prices 4.6% this year, up from an average of less than 2% in the past decade, and 2) the BoC’s Consumer Survey finds that the expectation of 1-year inflation has popped to 4.9%, more than double the pre-pandemic view. Looks like a trend.
The coming week will usher central banks back onto centre stage, and we’ll get a much better sense of how they are now viewing the inflation landscape. There’s a highly unusual meeting of the minds, with both the BoC and the Fed announcing rate decisions on Wednesday. (The central bank’s early version of Super Bowl day.) As Michael and Ben detail in Focus, at the very least, both are likely to warn—loudly—about the near-immediate need for rate hikes. And markets are already leaving the door swinging wide open for the BoC to begin the process next week.
While the timing and pace of the initial rate moves are interesting debates, the much bigger question is, to bring inflation to heel, how much will both need to tighten? At this point we still believe that a combination of relatively speedy rate action, QT, some calming in energy prices, and an improvement in supply chain issues suggest that central banks will ultimately need to not go much further than neutral (i.e., around 2%) to calm the inflation waters. Moreover, arguably both would be willing to tolerate inflation a bit above 2% later on in the cycle, since it could potentially fall hard in the next downturn (and recall that the Fed now aims to average inflation around 2% over the cycle). Finally, this week’s sour market reaction serves as a reminder that financial conditions may well also play a significant role in helping tame demand and, thus, inflation pressures.