After spending years in the shadows, inflation burst back onto center stage during the pandemic, hitting levels not seen since the 1980s when central banks raised interest rates aggressively to tackle enormous upward pressures on prices.

With central banks on hold and offering guidance that the next move in policy may be to cut interest rates, financial markets are behaving as if the inflation fight has already been won and at little cost to economic health – unemployment remains very low by historical standards amid lower, but not worrying, levels of economic growth and relatively robust investor confidence.

While higher inflation has historically weighed on the performance of both bonds and stocks, the situation today goes against those precedents. More than one stock market is trading near all-time highs, but ‘safe-haven’ bonds remain close to their lows following the market declines of 2022.

As a result, the debate around inflation continues and centers on whether, if at all, the dynamics of price pressures have altered in recent years.

What markets tell us

The view priced within bond markets has evolved in recent months, but asset prices suggest that inflation within developed markets is likely to glide down towards the central banks’ target of 2% this year. This will allow policymakers to ease monetary policy from the current restrictive levels and limit the fallout to the broader economy of higher interest rates.

With the yield curve inverted – debt with shorter maturities yield more than longer-dated debt – the bond market suggests that the current expected path of monetary policy, alongside a maturing economic cycle, will likely lead to a mild recession. That said, this view is less obviously priced in more recently given the ongoing upward surprises from the economic data.

This conclusion of benign inflation, lower (but not collapsing) growth, and supportive official policy have become the consensus. 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 re-accelerate as inflation comes down to meet central bank targets, allowing for both bonds and equities to perform.

Can rate expectations be wrong?

Investors must remain aware of the risks to this narrative, particularly as the markets have been wrong several times in recent years with growth and inflation surprising on the upside. Indeed, the resilience of developed market economies (especially the US) to a significant degree of monetary tightening in 2022 and 2023 has reignited the discussion on where the neutral, or equilibrium, rate of interest currently sits.

The neutral rate of interest is a nebulous theoretical concept and 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 investment demand. 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 effect – the economic effects aren’t immediate. But if neutral rates of interest are now structurally higher, current policy rate levels may not be as restrictive as central banks think. This means policymakers need not reduce interest rates as quickly, or as much, as is currently expected.

How inflation can still surprise

In terms of inflation specifically, the majority of the COVID-induced supply bottlenecks have been overcome, allowing goods-price pressures to ease, while there are also signs that the labor market is loosening – alleviating some of the wage and service-sector inflation.

The markets appear confident that these trends will persist and, as such, inflation expectations will continue to be contained as headline inflation plateaus close to 2%. The threats to this view, however, are numerous and justify the recent pragmatism shown by US central bankers when they emphasized the need to be data-dependent, rather than date-dependent when making decisions.

Keen to avoid the policy mistakes made by their predecessors at the Federal Reserve (Fed) in the 1970s and 1980s, they do not want to loosen policy prematurely while inflation remains a threat.

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 not be completely under control.

Higher for longer longer?

A focus on the risks of stubbornly higher inflation, rather than the damage to labor markets that a period of sustained high policy rates may cause, could cause central banks to err on the hawkish side – keeping rates higher for longer. Fed Chair Jerome Powell has expressed his concerns about the prospects of easing too soon.

If central banks wait too long before ‘normalizing’ interest rates, we may have not only an economic downturn but one that is exacerbated by an overly restrictive policy stance that cannot be loosened quickly enough when the economy slows too much.

Inflation tends to support stocks and bonds while it is falling towards the 2% target, as it generates hopes for a more accommodative policy. If inflation falls below target the consequences have historically been more negative, in large part due to the typically associated contraction in growth.

Even further falls in inflation (below target) would hurt earnings expectations if driven not by a recovery in the supply side of the economy, but by insufficient demand and its implications for business activity and consumption. Equities would sell off. But in this scenario ‘safe-haven’ bonds should do well amid policy easing.

Final thoughts

Hopes for a painless return to inflation-target levels seem excessive, with the risk of inflation settling on either side of target now complicating the task for central bankers who, only recently, could afford to focus solely on bringing inflation lower. They will now be judged on their ability to do so without causing unnecessary economic pain. Seldom has their job been less enviable.

Important information

Projections are offered as opinions and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.

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