Long-term inflation expectations have risen this year. In fact, just when central banks decided a few months ago to go the extra mile to push inflation down, expectations rose further. Are investors already preparing for a regime change regarding central bank policy?
For those who read my pieces here and there more often, know that I expect the pursuit of debt sustainability to become a dominant theme for central banks and thus financial markets. I do not believe that the two most logical solutions to bring down debt ratios - austerity and faster economic growth - are going to make it in practice. Few people and politicians are willing to support this.
So if you don’t want to question the financial system right away - I would exercise some restraint there - there have to be other, more accepted solutions. And two favourites are persistently low interest rates and controlled higher inflation.
Higher inflation
Of course, central banks still don’t want to know much about higher inflation targeting. But it is striking that the question is now being asked regularly - including during one of Powell’s press conferences. In view of the ever-growing mountain of debt, higher inflation is a real option within current policy frameworks. This may sound illogical after a period with the highest inflation in the past 40 years, but when you put on long-term glasses, you definitely come across this ‘solution’.
Now, of course, there are other factors that could push up long-term inflation. The current oil price, as striking as it is, is one of them. Historically, there has been a solid positive correlation between the oil price and long-term inflation expectations. The price of oil has risen by about USD 10, or 14 per cent, in the past two months, which may explain part of the rising inflation expectations.
Another reason is the increasing likelihood of a soft landing. Now, I still take into account a sizeable growth slowdown or recession, as the extreme stimulus measures by governments and central banks make it plausible that it will take longer for the negative effects of the series of interest rate hikes to show up. But with the Atlanta Fed GDP Nowcast estimating annualised growth of almost 6 per cent, that slowdown does not seem imminent.
Tightening cycle
Should the economy manage to get through this tightening cycle almost unscathed, the chances of a new spike in inflation increase correspondingly. The 1970s are known for giant inflation spikes that forced then Fed chairman Völcker to raise interest rates to unprecedented heights to contain the inflation monster.
Nonetheless, I do not rule out the possibility that between all the cyclical upsets, inflation expectations will move structurally higher. Probably a little at first and more if it becomes clear that conventional measures will not bring down the debt mountain. For now, oil and economic growth are more plausible candidates.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His chart of the week column appears every Monday on Investment Officer Luxembourg.