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The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
Markets spent most of 2021 trading on assurances from major central banks, and the US Federal Reserve in particular, that inflation would be transitory and monetary policy would continue to remain in uber stimulus mode. That powerful conditioning fuelled the “everything rally” in markets. 2022 will be different.
Markets will no longer have predictably massive liquidity injections to power them through uncharted and choppy economic waters. Crucially, investors will have to take a view on the durability and impact of the inflation surge, including the drivers of its eventual demise.
For more than a decade, large-scale central bank purchasing of assets boosted not just those being bought in markets but also virtually all other assets, be they financial or physical (such as housing, art and other collectibles). This was particularly the case in 2021, when cash injections from central banks were at record monthly levels.
After consistently dismissing 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 towards less monetary policy stimulus. While its policy stance will remain accommodative for quite a while, the world’s most powerful central bank is now set to completely stop its asset purchases 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 embarked on interest rate hiking cycles. All this comes at a time when fiscal policy in many countries is on the verge of being less stimulative, even though Omicron, the new coronavirus variant, is damping economic growth.
Having started late, the Fed faces challenges in reducing stimulus at a time when fiscal policy is less stimulative; market-based financial conditions are more volatile; strong household balances are being gradually eroded by inflation and solid consumer spending; and Omicron is fuelling inflationary pressures through new disruptions to supply chains and the availability of workers.
These challenges will not stop the Fed from increasing interest rates once it ends its asset purchases. But they do raise important questions as to the durability of the hiking cycle.
Already markets are pushing against the notion that actual policy will validate the interest rate path projected by Fed officials at their December policy meeting. What is not clear is whether this would be a question of willingness or ability.
The possibility of the Fed losing its nerve, as it has done repeatedly in recent years, would be viewed by markets as constructive in the short term. It would keep the central bank engaged in offsetting hits to asset prices, which is particularly supportive for equities that benefit from the “least dirty shirt phenomenon” (ie, not comprehensively attractive but better than the vast majority of other asset classes).
It would be even more supportive if this coincided with an orderly reduction in inflationary pressures, still the consensus view. This is still possible — just — if the Fed does 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 floored interest rates and ample liquidity would quickly prove unable to tolerate higher rates.
Tighter financial conditions, while warranted by persistent inflation, would foster a highly unfriendly combination of financial instability and lower private demand. In its extreme — that of stagflation — policies become a lot less effective at a time just when markets are dealing with the trifecta of hitherto-underpriced liquidity, credit and solvency risk.
Inflation would eventually come down in this “inability scenario” but through a process that risks a sudden sharp drop in economic activity.
As the new year unfolds, both the Fed and markets have a huge stake in inflation coming down in an orderly way. But the window of opportunity for policy to achieve this is rapidly closing. The alternative is a disorderly drop, which would involve the even bigger Fed policy error of having to be too abrupt in tightening monetary policy after being way too slow previously.
In addition to the direct damage to the economy, this would probably lead to financial market accidents that amplify another round of unnecessary, and much larger, harm to livelihoods.
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