Over the past few days, I have received inquiries and comments on inflation and central bank policies that point to heightened uncertainty. The range is wide. On the one hand, it is emphasized that the phase of high inflation rates is only temporary because it is energy price- and pandemic-related. Therefore, key rate hikes would be a policy mistake. On the other hand, however, there is also the opinion that key rates are clearly too low because we are experiencing a regime change toward persistently higher inflation rates.
Choosing the right side will have a significant impact on the development of a securities portfolio. Unfortunately, it will be some time before macroeconomic indicators clear the fog. Moreover, there may be a third possibility that indicates a way out of the phase of heightened uncertainty. Investors are in good company. Central banks have also been surprised and unsettled by high inflation rates. This has brought about a change in strategy in the basic stance of monetary policy.
Strategy 1: dovish policy
Before the period of high inflation rates, central banks wanted to pursue a slow normalization strategy. In the first year of the pandemic, expectations were for cautious rate hikes only starting in 2024. Over the past decade, inflation in the advanced economies has been too low, i.e., below the respective central bank target. A prolonged period of economic expansion and a positive output gap (overheating) should help to improve the supply side (fallen labor market participation rates, fallen employment rates, fallen productivity growth), which was adversely affected by the pandemic.
Strategy 2: hawkish signals
Persistently high inflation rates and increasing secondary round effects (higher transport and energy costs exert general cost pressures) increase the risk of (significantly) rising inflation expectations. In addition, although the labor market is not (yet) strong (employment rates slightly above pre-pandemic levels in an increasing number of countries), it has become tight surprisingly quickly. Unemployment rates are reaching low levels in more and more countries, more precisely the NAIRU (Non Accelerating Inflation Rate of Unemployment) range. This is the level below which pressure for rising inflation rates increases. Central banks cannot particularly influence current inflation rates. The higher prices for energy, transport and food have little to do with the low level of interest rates. Central banks can, however, try to prevent a pass-through from current high inflation rates to inflation expectations by sending sharp (hawkish) signals. The new policy is an earlier and faster exit from the expansionary monetary policy stance. By the end of the year, key interest rate hikes totaling 1.6 percentage points to 1.7% are priced in for the US, and 0.46 percentage points to -0.12% for the eurozone. The neutral interest rate level is to be reached earlier. This is the interest rate assumed to have neither a supporting nor a dampening effect on economic activity. For the USA., the market is pricing in a neutral interest rate of just under 2%, for the euro zone around 1% (measured by the priced-in interest rate with a five-year maturity in five years).
Strategy 3: restrictive monetary policy
If inflation expectations drift upward despite an earlier and faster exit, central banks would be forced to prevent a positive output gap via a cooling of demand (economic growth) to meet the inflation target. The policy rate would be raised above the neutral level, meaning monetary policy would become restrictive. Classically, recession risk would rise because central banks have often overdone it with interest rate hikes in the past.
Interest rate hikes expected
In the developed economies, market expectations for significant key rate hikes have risen rapidly. These have halted the carry investment regime. Stable short-term interest rates no longer lead to indiscriminate demand for yield premiums for credit risk (TINA for There Is No Alternative to Risk Assets). For investment grade bonds, the focus is on interest rate sensitivity (duration risk) and the break-even spread (the negative effect of interest rate increases is just as large as the positive effect of the yield premium). For risky (below investment grade) bonds, credit risk is considered more closely: Higher refinancing and repayment risk due to higher interest rates. In addition, higher yields put pressure on asset class valuations (lower prices). In other words, rising government bond yields mean that government bonds are more attractive, putting pressure on riskier forms of investment.
Notice: Past performance is not a sufficient indicator of the future performance.
Supportive Financial Conditions
The immediate key question is whether the overall financial environment (financial conditions) merely becomes less accommodative or even restrictive. As long as a neutral interest rate level is sufficient for stable inflation expectations, the change in central bank policy generates asset price fluctuations, but financial conditions do not become restrictive (baseline scenario). The fear that a restrictive interest rate level is needed to contain inflation expectations (including an increasing probability of recession) is part of a risk scenario.
Rising neutral interest rate level
In the medium term, however, it is at least as important whether the neutral interest rate level will rise. There has been a heated debate about this for years. The arguments in favor of a rising trend in interest rates are that demographic developments (aging), the high investment requirements to combat climate change and generally persistently high budget deficits could lead to a declining savings surplus. If this were indeed the case, central banks would have to raise more than thought without the interest rate level having a restrictive effect on the economy. But pronounced rate hikes to a new, higher neutral level would be restrictive for financial conditions. This is because downward pressure on the valuation of numerous securities classes would increase. Moreover, this pressure would be structural in nature and not merely cyclical as in the case of a recession.
Conclusion
What remains is that as long as inflation expectations remain stable, i.e. do not drift significantly and persistently upward, central banks will raise key interest rates to a neutral level sooner and faster. In this environment, the financial environment will remain positive, even if asset price fluctuations increase. In the two risk scenarios (recession risk or higher neutral interest rate), the trade-off between fighting inflation and financial stability increases.
Legal note:
Prognoses are no reliable indicator for future performance.