High inflation and the consequences of attempts to curb it are a top concern for investors nowadays. By hiking rates, policymakers can eventually slow demand to subdue price pressures, even in an environment of constrained supply. However, this process takes time.
Prices reflect the interaction between supply and demand: when demand outstrips supply, prices must rise to re-equilibrate the economy. In fact, supply-side constraints are beyond the purview of monetary policy. In other words, many of the forces pushing prices up are beyond central banks’ control so they cannot solve these issues by changing interest rates. What they do is to slow demand such that even in an environment of constrained supply, price pressures abate, which means tightening monetary policy to slow growth to a rate consistent with the ability of the supply side of the economy to keep pace.
Once rates rise, it takes time for the economy to feel the effect in full. Higher policy rates will not translate immediately into lower demand, slower growth and an easing of inflationary pressures; however, as this year progresses, we can expect growth to slow, bringing inflation gradually lower.
As part of the growth slowdown, consumers will increasingly spend on services rather than goods. Another part of the upcoming rotation is a natural re-equilibration in an environment of higher prices. Since demand for goods has been robust and goods trade has been particularly impacted by supply-chain disruptors, goods price inflation has soared. Food prices, in particular, have risen largely due to high crop prices. 2021 was particularly a bad year for supply, as weather limited planting in many regions and interfered with the growing season. This has made services comparatively affordable and thus more attractive.
However, the shift from goods consumption back to services may take longer than expected. While airlines, hotels and restaurants make headlines, nearly half of the gap in services demand is for medical services. Some of this is likely to be from postponed elective procedures, which could rebound sharply when people feel more comfortable resuming daily life. However, people may take it longer to reach that point.
Prices do not have to fall for inflation to decelerate. Inflation measures the rate of change in prices rather than the price level. Importantly, inflation is not just a one-time change in prices, but a persistent increase. Even if prices simply rise at a slower pace, inflation will turn lower. This means that over time, goods prices and services prices will converge and that inflation will eventually fall below services inflation. Pushing goods prices inflation lower will make a big difference in overall inflation, though it will not solve the problem entirely.
One of the biggest categories of services inflation is how the consumer price index captures the cost of housing. Housing is the part of the economy most sensitive to monetary policy. Mortgage rates in the US have soared and housing prices have risen over the past few years so affordability is extremely low. Subsequently, mortgage applications have fallen sharply and sales of homes, both new and existing homes, have turned down. This suggests that home prices are likely to slow their rate of increase, which should eventually bring services inflation lower too.
To understand ongoing increases, it helps to look at inflation on a month-over-month basis. Doing so eliminates past price rises from the equation, so investors can focus on what is changing now and in the future. The best way to monitor progress toward the outcome is through a broader assessment of financial conditions. Measures and indicators such as lower equity prices, wider credit spreads and higher Treasury yields all work to slow demand by transmitting monetary policy from central banks to the economy. The current financial conditions indicate an economic slowdown is in motion and will in turn bring inflation lower. The key question over the medium term is how aggressively central banks will tighten policy once evidence of slowing growth mounts. Inflation tends to lag the cycle, staying high even after growth slows. If central banks remain aggressive during that interval, the risks of a recession rise sharply.
Dr. Chenjiazi Zhong 钟陈佳子 
Uncertainty Clouds the Outlook
An anti-goldilocks economy refers to the global economy where policymakers are confronted with a stagflationary supply shock, which is negative for growth and will tend to push up inflation further. In the current market condition, inflation is “too hot,” as evidenced by the higher energy and food prices, as well as the disrupted supply chains and trade. Globally speaking, energy and food prices have been increasing significantly since late April of 2020, while supply chains and trade flows have been lowering since May of 2020. On the other hand, economic growth is “too cold,” as indicated by the tighter financial conditions since year-end 2020 and the lower business and consumer confidence due to uncertainty.
Significant uncertainty clouds the outlook; however, the baseline development-market (DM) growth remains above trend, especially in the US, assuming a 1.5% DM real GDP growth. DM inflation, as measured by core CPI inflation, peaks at elevated levels, the target of which was 2%.
The current global markets witness greater divergence and dispersion of outcomes among countries and regions: DM exposure to Russia varies across the US, the UK, and the eurozone. Italy has approximately 21% of all outstanding loans to Russia, accounting for 2.5% of all the foreign claims (FCs) of Italian banks. Austria has nearly 14% of outstanding loans, representing 3.7% of all Australian banks’ FCs. France’s loans are also approximately 21%; however, they are just 0.7% as a share of total FCs. No other European economies have Russian FCs exceeding 0.4% of their totals. The direct impact on European banks’ balance sheets from Russia exposures will be relatively low. On the emerging-market (EM) side, looking at EM commodity exporters and importers, winners and losers are highly divergent, as indicated by the commodity trade balance as a percentage of GDP.
On volatility across equities and rates, although modest in absolute terms, equity volatility, as measured by the VIX index, has increased, especially since May of 2021. Meanwhile, rate volatility, measured by the CBOE interest rate volatility index, has picked up amidst inflation concerns.
Policymakers struggle to balance higher inflation against greater uncertainty. Higher and more broad-based inflation raises the risk that inflation expectations become unanchored. Market expectations for year-end 2022 policy rates are higher across the Fed and the key central banks; however, central banks are unlikely to ride to the rescue, increasing the risk of weaker growth or even a recession. In the US, different indicators imply that it may already be in the late cycle. Elevated inflation will continue to drive rate markets.
A decrease in demand from the Fed has raised mortgage rates and cheapened valuations. As of March 22, 2022, Agency MBS spreads have widened almost 40 basis points (b.p.) since the Fed announced its intention to taper MBS purchases, back to its cheapest levels in two years. Higher rates and wider spreads have caused mortgage rates to rise, likely lowering MBS supply, extending outstanding MBS, and increasing yield potential. As of March of 2022, the conventional 30-year mortgage rate was 4.51%.
Further on credit, spreads have retraced well above their post-pandemic tights. Investment-grade credit indices have largely recovered from the COVID-19 sell-off; however, sector dispersion remains high. The recovery trade in select resilient corporate credits that have ample liquidity, particularly hardest-hit sectors such as travel and leisure, may be poised to outperform and offer further upside to a reopening of the economy.
Lastly, the financials sector, especially banks, benefit from strong balance sheets with an average investment-grade rating, which can deliver attractive yields. As of Feb 28, 2022, the average yield for the European additional Tier 1 market was 561 b.p. and that of the global high yield market was 526 b.p.
In fact, higher rates may prove to be an attractive entry point, as index yields per unit of interest rate risk are historically low. As of Feb 28, 2022, the yield-to-duration ratio of the Bloomberg US Aggregate index was 0.35, and that of the Bloomberg Global Aggregate was 0.24. Dispersed valuations reinforce the importance of active management and selection. In the current market conditions, portfolio flexibility and liquidity are the crucial.
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