High inflation rates increase downside risks

High inflation rates increase downside risks
High inflation rates increase downside risks
(c) Daniel Reinhardt / dpa / picturedesk.com
Share post:

Inflation rates continue to rise, prompting central banks to accelerate rate hikes. Last week, consumer price inflation in the US surprised on the upside with a 1.0% month-on-month increase in May to 8.6% year-on-year. With the Reserve Bank of Australia and the European Central Bank, two previously moderate central banks have moved into the hawkish camp. In line with this, the financial environment has deteriorated, with equity prices falling, yields on credit-safe government bonds rising, and credit spreads increasing. For all these reasons, downside risks to real economic growth, i.e. recession risks, have increased. In particular, consumer sentiment indicators are falling as high inflation rates reduce purchasing power. Last week, consumer sentiment in the US for the month of June (preliminary estimate by the University of Michigan) fell to an all-time low. At the same time, long-term inflation expectations (same source) continued to rise (3.3% p.a.).

Uncertainty about future developments is very high for three reasons

First, there is considerable uncertainty about the size of the output gap. Second, the (apparent) understanding of inflation dynamics is low. This applies to both market participants and central banks. As a result, it is also unclear how much economic growth will have to cool down in order to achieve the central bank’s inflation target in the medium term. Third, there is considerable uncertainty in the estimate of the relationship between monetary policy and economic growth. How many key interest rate hikes are needed to cool economic momentum to a certain extent? Complicating matters is the fact that monetary policy only affects the economy with a time lag of six to eighteen months, and inflation is a lagging variable to the economy. This creates uncertainty as to whether the central banks will manage a soft landing for the economy or ultimately trigger a recession.

Uncertainty Output Gap

If the economy is already operating very far above potential, a restrictive interest rate policy is necessary (which triggers a recession). If the production level is only slightly above potential, a soft landing is possible. The risk here is that the central bank fails to fine-tune the policy and that overly vigorous rate hikes trigger a mild recession.

Uncertainty Inflation dynamics

In principle, the issue here is whether economic agents are thinking rationally about inflation or merely reacting to past inflation.

Rational Inflation Expectations

In the first model, there is no inflation spiral. When current inflation is above trend inflation, there is a rational expectation that inflation will fall. For the story of only temporarily elevated inflation to remain credible, central banks need to set only moderate actions. Policy rates are raised to a neutral interest rate level. In this case, the real interest rate level remains low (at zero percent). A soft landing of the economy is possible. Until recently, the European Central Bank was in this camp, having only signaled key rate hikes at a moderate pace. Here, the risk lies in a policy that is too restrictive (too rapid increases to an interest rate level that is too high).

Adaptive Inflation Expectations

In the second model, an inflation spiral can be set in motion. This is because there are adaptive expectations that inflation will be high (or even higher) next year because it has been high (or rising) this year. In this case, central banks are under pressure to cool economic activity enough to break the inflation trend. This scenario implies a recession because real interest rates have to be raised significantly into positive territory. No central bank is currently in this camp, but it represents the greatest risk for markets.

Mixed model

A mixed model number three is also conceivable. As long as underlying inflation is at a low level, economic agents do not think much about inflation. The inflation trend fits (perhaps coincidentally) with the rational expectations model. But when inflation rises and remains above a critical level for a long time (the inflation trend rises), a regime change occurs. Economic agents become concerned about future inflation. Currently, the hope of central banks is to just avoid a regime change. Central banks are raising interest rates to neutral as quickly as possible because inflation rates have risen significantly, in order to prevent the tipping point into the inflationary spiral regime. More and more central banks in the developed economies are coming into this camp.

Last week, the formerly moderate (dovish) central bank in Australia (Reserve Bank of Australia) raised the key interest rate by 0.5 percentage points to 0.85%, after having raised the key interest rate by 0.25 percentage points in May. Last Thursday, the European Central Bank announced a gradual rate hike of 0.25 percentage points for July. Another rate hike was announced for September. The surprisingly hawkish statement was that a larger increase (0.5 percentage point) will be appropriate should the medium-term inflation outlook remain (not decline) or worsen. Next Wednesday, the US Federal Reserve will (very likely) raise the federal funds rate another 0.5 percentage points to 1.5% (upper band for the federal funds rate).

Conclusion

A soft landing of the economy is thus possible under three main conditions. First, the output gap is only slightly positive (no overheating). Second, inflation dynamics can be described as either purely rational or rational up to a tipping point. Third, central banks manage to cool economic growth to the exact extent desired. Corollary: Downside risks have increased as inflation rates have risen.

For a glossary of technical terms, please visit this linkFund Glossary (erste-am.at)

Legal note:
Prognoses are no reliable indicator for future performance.

RESPOND TO THE ARTICLE

Leave a comment Required fields are marked with *

Your email address will not be published.

Legal disclaimer

This document is an advertisement. All data is sourced from Erste Asset Management GmbH, unless indicated otherwise. Our languages of communication are German and English.

The prospectus for UCITS (including any amendments) is published in Amtsblatt zur Wiener Zeitung in accordance with the provisions of the InvFG 2011 in the currently amended version. Information for Investors pursuant to § 21 AIFMG is prepared for the alternative investment funds (AIF) administered by Erste Asset Management GmbH, pursuant to the provisions of the AIFMG in connection with the InvFG 2011.

The fund prospectus, Information for Investors pursuant to § 21 AIFMG, and the key investor document/KID can be viewed in their latest versions at the web site www.erste-am.com within the section mandatory publications or obtained in their latest versions free of charge from the domicile of the management company and the domicile of the custodian bank. The exact date of the most recent publication of the fund prospectus, the languages in which the key investor document is available, and any additional locations where the documents can be obtained can be viewed on the web site www.erste-am.com. A summary of investor rights is available in German and English on the website www.erste-am.com/investor-rights as well as at the domicile of the management company.

The management company can decide to revoke the arrangements it has made for the distribution of unit certificates abroad, taking into account the regulatory requirements.

This document serves as additional information for our investors and is based on the knowledge of the staff responsible for preparing it at the time of preparation. Our analyses and conclusions are general in nature and do not take into account the individual needs of our investors in terms of earnings, taxation, and risk appetite. Past performance is not a reliable indicator of the future performance of a fund. Please note that investments in securities entail risks in addition to the opportunities presented here. The value of shares and their earnings can rise and fall. Changes in exchange rates can also have a positive or negative effect on the value of an investment. For this reason, you may receive less than your originally invested amount when you redeem your shares. Persons who are interested in purchasing shares in investment funds are advised to read the current fund prospectus(es) and the Information for Investors pursuant to § 21 AIFMG, especially the risk notices they contain, before making an investment decision. If the fund currency is a currency other than the investor's home currency, changes in the corresponding exchange rate may have a positive or negative impact on the value of his investment and the amount of the costs incurred in the fund - converted into his home currency.

Please consult the corresponding information in the fund prospectus and the Information for Investors pursuant to § 21 AIFMG for restrictions on the sale of fund shares to American citizens. Misprints and errors excepted.