How the inflation riddle could affect markets

• The risk of inflation settling above or below central banks’ target is complicating interest rate decisions.

• Most of the Covid-induced supply bottlenecks have been figured out, easing inflation as a result – but there are a host of reasons to believe that inflation may still not be completely under control.

• Central banks may err on the cautious side, keeping rates higher for longer, if they’re more focused on the risks of inflation. If central banks wait too long before “normalizing” interest rates, the economy could take a turn for the worse, and central banks may not be able to trim interest rates fast enough to spur it on.

Inflation burst back onto center stage during the Covid pandemic after spending years in the shadows, hitting levels not seen since the 1980s. And while central banks still aren’t confident enough to pull the trigger on interest rate cuts, financial markets are behaving as if the inflation fight has already been won. What’s more, the economy has (so far) handled the whole shebang pretty well: the job market is holding firm, unemployment is very low by historical standards, and overall economic growth hasn’t stalled enough to cause panic.While higher inflation has historically weighed on the performance of both bonds and stocks, the situation today goes against those precedents. Multiple stock markets are trading near all-time highs, but so-called safe-haven bonds are sitting close to their lows of 2022.Let’s take a look at what’s making the inflation topic less than straightforward, and what that means for central banks’ decision-making.

What are the markets telling us?

The consensus priced into bond markets has changed in recent months, but seems to suggest that inflation within developed markets is likely to head toward central banks’ target of 2% this year. If that happens, policymakers could ease monetary policy from the current restrictive levels, which should limit the impact of higher interest rates on the broader economy.

The notion of a so-called soft landing in the US – victory over inflation while avoiding a recession – which seemed unrealistic only a year ago, looks within reach. Earnings growth could speed back up as inflation comes down to meet central bank targets, allowing for both bonds and stocks to do well.

There’s still a chance of a bumpy landing, though. The bond market suggests that the current expected path of monetary policy, alongside a maturing economic cycle, could lead to a mild recession. The yield curve is inverted, see: debt with shorter maturities is yielding (or paying) more than longer-running equivalents. That said, this view is less obviously priced in more recently given the ongoing upward surprises from the economic data.

Can rate expectations be wrong?

Still, it’s worth remembering that markets have been wrong several times in recent years, with both economic growth and inflation positively surprising investors.

This time around, onlookers can’t even decide on where the “neutral” interest rate should land. Developed market economies (especially the US) have handled high rates remarkably well, suggesting that the economy may be able to thrive while rates are set at a higher point than they previously have been.

The neutral rate of interest is the subject of fierce debate. It is closely related to economic growth and is also the interest rate that balances an economy’s supply of savings with demand for investment. Both are influenced by a wide range of factors operating over different time horizons.

It is widely accepted that monetary policy acts with a lag – the economic effects aren’t immediate. But if neutral interest rates become structurally higher, current policy rate levels may not be as restrictive as central banks think. As a result, policymakers might not need to reduce interest rates as quickly, or as much, as is currently expected.

Could inflation still surprise us?

The majority of Covid-induced supply bottlenecks have been figured out, easing inflation as a result. There are also signs that the labor market is relaxing, alleviating some of the wage and service-sector inflation.Markets appear confident that these trends will stick around, which should keep inflation within a certain range while it heads toward the 2% point.

However, keen to avoid the policy mistakes made by their predecessors at the Federal Reserve (the Fed) in the 1970s and 1980s, central bankers don’t want to loosen their grip on inflation until they’re sure that it’s stamped out. They’re waiting to see concrete data of that before they can even look at the rate-cut button.

Whether it be renewed threats to global supply chains, an escalation of geopolitical tensions, costs associated with the climate transition, or labor-market dynamics, there are a host of reasons to believe that inflation may still not be completely under control.

Could rates still stay higher for longer?

Central banks may err on the cautious side, keeping rates higher for longer, if they’re more focused on the risks of inflation. The Fed’s chair Jerome Powell has expressed his concerns about the prospects of easing too soon.

If central banks wait too long before “normalizing” interest rates, the economy could take a turn for the worse, and central banks may not be able to trim interest rates fast enough to spur it on.

Inflation tends to support stocks and bonds while it is falling toward the 2% target, as it sparks hopes for lower rates. But if inflation falls below target, the consequences have historically been more negative. If the reason for the price decline was a lack of demand, that wouldn’t bode well for businesses or their stocks – although bonds would likely benefit from any resulting drop in interest rates.

What’s the takeaway?

The risk of inflation settling on either side of the target is complicating central bankers’ decisions. Until recently, they could only afford to focus on bringing inflation lower. Now, they’ll be judged on their ability to do so without causing unnecessary economic pain. That’s not exactly an enviable position.

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