2022 questions: expected inflation, unexpected implications
Market participants will soon be writing their 2022 outlook pieces. There are three points that I think will be central to almost all of them:
- Bottleneck-induced inflation will be with us until at least the second half
- Expect wage pressure
- Central banks will deem that inflation is persistent enough and labour markets strong enough to require monetary tightening
We’re focused on what we believe the next two questions will be:
- How high do rates need to go?
- When rates go up, what breaks?
We think that if central bankers truly want to nullify the impact of the stimulus that’s been handed out, interest rates may have to rise a lot. As we wrote in February, there is a credible case that the combination of government handouts and quantitative easing will result in surprising pressures.
Wiggle room and flatter curves
The dynamic we think is most interesting is that nobody can have much confidence on how high rates need to rise. It only becomes clear when they've gone “too far.” Before then, it’s very difficult to calibrate how the sensitivity of an economy has changed.
The Reserve Bank of New Zealand is among central banks that might be leaving itself some wiggle room. Its August monetary policy report contains a chart (linked here, on page 31) that graphs the neutral interest rate indicator over the past 20 years, meaning the rate needed for “neither expansionary nor contractionary” policy. While the average has fallen over time, the range of the “suite” of indicators generating that average has widened to between 1.5% and 4.5% -- about as wide as the Kiwi interest-rate cycle, peak to trough, over the past decade!
The only thing we will say with confidence is that market participants will have a hard time believing rates can meaningfully pass the peak of the last cycle without proof. And because the only proof is in observing how the economy reacts to rate hikes, they will have a hard time believing interest rates will meaningfully pass that peak until rates have already risen.
This means that, if we're on a journey to surpass the last cycle’s peak, we believe we'll get there with very flat interest-rate curves.
The glut of money created isn't the only thing that makes this time (potentially) different. Here are three other areas we're thinking about carefully:
- The politics of climate change have shifted, potentially leading to less globalisation if border taxes on goods are legitimised as a tool to level the international environmental playing field. This implies potentially more domestic production – and inflation as a more local phenomenon.
- Office geography. Many industries that had previously been immune to globalisation have realised they can operate with employees spread across the globe. If the services workforce becomes truly global, it has the opposite impact of the point above: we need to start thinking about inflationary pressure in services as a less local phenomenon.
- Many older workers aren't returning to the workforce after the pandemic, choosing to fully or partially retire. We need to look carefully at how pensioners are funding their consumption and their ability to continue spending.
Our focus is not on guessing what will happen (e.g. will governments use border taxes as a way to onshore production and increase domestic employment?). Our focus is on the framework: what we would expect to see if these things are happening, and when the data is available to allow market narratives to form.
We're looking for dynamics -- like the persistent flattening we expect to see if rates go higher -- that may be misunderstood or misinterpreted, and thereby create opportunities.
You can read my blog on the year-end dynamics in government bond markets here.