The author is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy.
Markets traded for most of 2021 on assurances from major central banks, and the US Federal Reserve in particular, that inflation would be transient and that monetary policy would remain in uber-stimulus mode. That powerful conditioning fueled the “all-rally” in markets. 2022 will be different.
Markets will no longer predictably have massive liquidity injections to drive them through unknown and turbulent economic waters. Of paramount importance is that investors take a view on the sustainability and impact of the inflation surge, including the drivers of its eventual downfall.
For more than a decade, large-scale central bank purchases of assets have not only boosted those bought in markets, but also virtually all other assets, whether financial or physical (such as housing, art and other collectibles). This was especially the case in 2021, when cash injections from central banks were at record monthly levels.
After the Fed consistently dismissed the threat of inflation, the Fed’s “better late than never” pivot on the issue is part of a general shift in global central banking to less monetary policy stimulus. While its policy stance will remain accommodative for some time, the world’s most powerful central bank is now ready to halt its asset purchases completely by the end of the first quarter.
An increasing number of other central banks (not only in the emerging world, but also in some advanced economies such as Norway and the UK) have already started interest rate hike cycles. It all comes at a time when fiscal policy in many countries is on the verge of being less stimulating, although Omicron, the new coronavirus variant, is dampening economic growth.
After starting late, the Fed faces challenges in reducing stimulus at a time when fiscal policy is less stimulating; market-based financial conditions are more volatile; strong household balances are gradually being eroded by inflation and solid consumer spending; and Omicron fuel inflationary pressures through new supply chain disruptions and worker availability.
These challenges will not stop the Fed from raising interest rates once it has ended its asset purchases. But they raise important questions about the durability of the step cycle.
Markets are already pushing against the idea that real policy will validate the interest rate path projected by Fed officials during their December policy meeting. What is not clear is whether this would be a matter of willingness or ability.
The possibility that the Fed will lose its nerve, as it has repeatedly done in recent years, will be seen by markets in the short term as constructive. This will keep the central bank offsetting asset prices, which is particularly supportive of equities benefiting from the “least dirty shirt phenomenon” (ie not comprehensively attractive, but better than the vast majority of other asset classes).
It will be even more supportive if it coincides with an orderly reduction in inflationary pressures, still the consensus view. This is still possible – only – if the Fed acts more immediately to catch up with developments on the ground.
The “inability” scenario would be more problematic. Here, a system conditioned by more than a decade of reduced interest rates and ample liquidity will quickly prove to not tolerate higher rates.
Stricter financial conditions, although justified by sustained inflation, will promote a highly unfriendly combination of financial instability and lower private demand. At its extreme – that of stagflation – policies become much less effective at a time just when markets are dealing with the trifles of hitherto underpriced liquidity, credit and solvency risk.
Inflation will eventually decline in this “inability scenario,” but through a process that jeopardizes a sudden sharp decline in economic activity.
As the new year unfolds, both the Fed and markets have a major stake in inflation declining in an orderly fashion. But the window of opportunity for policy to achieve this is closing fast. The alternative is a disorderly decline, which would involve the even bigger Fed policy error that it would have to be too sudden to tighten monetary policy after it was completely too slow before.
In addition to the direct damage to the economy, it is likely to lead to financial market accidents that increase another round of unnecessary, and much greater, damage to livelihoods.