The Monetary Policy Dilemma and Market Conundrum

After many years of an accommodative monetary regime, with little inflationary effect, central banks now find themselves with the need to respond to runaway inflation. Their challenges are amplified by the fact that they continued to inject liquidity and control the behavior of the entire yield curve much longer than was necessary or justifiable. Caught in their complacency, they failed to recognize that there is a major shift in global economic trends. In particular, the era of globalization and its benefits of better efficiency and declining prices started to show its cracks even before Covid. Yet, central banks failed to recognize the inflationary effect of such a change and its likely long-lasting effect on prices. Consequently, when Covid triggered supply chain disruptions and price increases, they wrongly assumed that such increases will be transitory.

After some delay, in which they were first in denial and later believed that small and gradual adjustments to interest rates will be required, at the price of significant damage to their credibility, central banks were forced to act at a rapid pace that sent shock waves through the financial markets. The markets are currently caught in the headlights of the rapid Fed rate increases to the point where they believe that the Fed will start to reverse rates in 2023. In other words, they believe that the rate increases will be transitory. Just as the Fed erred to believe that the inflation will be transitory, the markets are likely to be wrong in the assumption that the rate increases will be transitory.

For starters, we are in an environment of significantly negative real interest rates, which will not change in the near future. The Fed still needs to raise rates in order to regain some level of credibility. Furthermore, given their past mistakes, they are not likely to reverse course unless they are convinced that they were able bring inflation down to more moderate levels. Given the inflationary effect of deglobalization, the continuing disruptions in the supply chains, the dislocations of the job markets and the lags in price increases filtering to the official price reports, we are likely to see elevated price level for an extended period. Another variable in the Fed equation is the level of economic activity and whether their actions are likely to cause a deep recession. While the markets and the media are focusing on the low-income part of the population and the shock effect of the recent Fed actions, the real effect on the economy is likely to be limited. Most of the population is still in an environment of ample cash and a high level of personal wealth, following many years of liquidity and appreciating assets, and most importantly a willingness to spend in the aftermath of Covid. Once the shock effect of the recent Fed actions (the pace of the increases rather than the level of interest rates) subsides, we are likely to see renewed momentum in the economy accompanied by moderating, yet high, inflation levels. In this case, the Fed will need to raise rates further in order to regain its footing and will not be in the position to cut rates anytime soon. Supporting such a scenario is the fact that companies (other than the inflated SPACs and high-tech companies) are in good shape regarding their balance sheets and ability to invest once the dust settles. The exception to this scenario involves a deeper economic decline which will be caused by the supply chain disruption and the shortage in raw materials and components. Yet, in such a situation, the upward pressure on prices would be even stronger.

The current consolidation in the markets and modest reversals are likely to be short lived as the persistent inflation and the need by the Fed to continue with their interest rate increases, even if it is at a slower pace, will need to be priced into the fixed income markets, US Dollar values, and, in a discriminatory manner, into the stock markets. Commodities will continue to price in the effects of supply disruptions and the level of economic activity.