Captain Bligh tells his rebellious crew in the movie Mutiny on the Bounty that “beatings will continue until morale improves.” Bligh’s strategy backfires, despite the fact that he eventually reaches safety. The phrase “beating until morale improves” is perhaps more appropriate for the financial markets, though. As a very general rule, they (market prices) frequently rise to painful levels when there are underlying imbalances or economic stress.
The past few weeks have been a great example of this. For instance, abrupt changes in commodity prices have led to hardship, political unrest, and increasingly, unrest (Sri Lanka for instance). This adds a layer of socio-political complexity to the conversation about markets. Free moving prices have an advantage over those controlled by quantitative easing in that they convey information about the state of the global economy and its moving parts. The implications of these should be considered by policymakers (will there be fuel shortages and power outages this winter?)
food shortage
There is also a counterargument that calls for restrictions on sudden price changes that threaten people’s means of subsistence. In some ways, that is challenging to do consistently, and in the end, that is largely the responsibility of central banks, the majority of whom have fallen short of their goals. We should anticipate that many anxious governments will deplete their fiscal capital for the remainder of this year.
The dollar, whose recent strength has resulted in yen weakness and is currently pushing the euro towards parity with the dollar, is one market signal that is worth paying attention to. A number of emerging market currencies, like the Chilean peso, have also fallen in value. A more comprehensive interpretation of these movements is that the strength of the dollar is signaling demand by investors for safe(r) assets and money. At one level, these moves can be interpreted as individual regional stresses (German trade weakness in particular). If dollar strength continues, there should be cause for concern because it is a sign of what is happening in portfolios and because of the potential for spillover effects that could lead to a mini-dollar crisis (see this note from David Skilling titled “Our Dollar, Your Problem”).
The pain trade is still likely to be present now that we have reached the halfway point of the year and have experienced multiple sell-offs, the most recent of which was in commodities, but it may manifest itself in two very different ways, both of which will have significant socioeconomic consequences in the years to come.
Rates of up to 5%?
It’s possible that central bankers will start to tone down their message about “killing off” inflation as a result of the decline in commodity prices, particularly those of their more politically sensitive components (such as gasoline prices). Particularly, it is still unclear whether central bankers possess the levels of monetary sadism necessary to tolerate the unintended economic and political consequences of effectively suppressing inflation. They might take the stance of “living with higher prices, avoiding recession” in that regard.
An “inflation permissive” message from central bankers would usher in a new market and economic regime, even though this is to some extent already priced into interest rate markets (they anticipate the Fed to cut rates through 2023 and mortgage rates are declining from a high level).
Bond markets would deteriorate, while commodities would rise as an inflation hedge and stocks of businesses with pricing power would increase. Given the actual impact of high inflation/steady rates on debt, it’s also possible that companies with high debt levels would see an increase in their equity value. However, in terms of the economy, the possibility of a higher trend level of inflation could result in upward pressure on wages, at least for those who have bargaining power, and in general, would result in a relative transfer of wealth from asset-poor, lower income workers to wealthier, higher earners.
Sado-monetarism
To continue the fight to flatten inflation is another monetary avenue that the Federal Reserve and other central banks can take (for the moment the most likely scenario). The Fed has been unusually raising interest rates in the face of record-low consumer confidence, and they would continue to do so until inflation overshot to the downside in this attempt to increase their credibility in the face of weakening economic activity (early next year).
The result in terms of wealth would be a more virulent deflation in asset values, most notably in developed-world home prices (Australia, Canada, the US are vulnerable). The economic impact would be a severe recession and a significant decrease in the wealth of the upper classes. Politically, a number of governments would suffer simply by association (even though Biden’s approval ratings are already strongly inversely correlated with inflation), and it’s possible that the relationship between politicians and central bankers will drastically deteriorate.
Understandably, many central bankers would like to see inflation disappear, and to a large extent, supply chain disruptions and commodity price increases are abating. Rent increases and service price inflation remain a possibility, and these increases could end up being stubborn and difficult to reverse. In order to best distribute the economic “pain” and preserve social cohesion during a period of significant change, it will be difficult to resolve these pressures and will require coordinated action from governments and central banks (mindful of the political consequences of the 2009 global financial crisis).
