Franklin Templeton Fixed Income chief investment officer Sonal Desai said that based on price action, the consensus view is that the Federal Reserve (Fed) might nudge rates up a few more notches to stay on the safe side, but that soon enough, we’ll go back to a world of very low interest rates.
This view is being fuelled by the encouraging US December Consumer Price Index (CPI), which saw headline inflation fall 0.1 per cent from the previous month, pushing the year-over-year rate down to 6.5 per cent from November’s 7.1 per cent. Core inflation (excluding food and energy) slowed to 5.7 per cent from 6.0 per cent.
“I think markets are still too optimistic on inflation and underestimate a very important shift in central banks’ attitudes,” Ms Desai said.
She said that macro policies are still relatively loose and that while “supply shocks are fading out, rent inflation will likely soon peak, and there is some weakening in economic activity”, it isn’t enough.
“This weakening is nowhere near enough of what’s needed to pull inflation down to 2 to 3 per cent because there are a number of inflationary forces still at work,” Ms Desai said.
She added that markets and many analysts have a ‘glass half-full’ view of wage growth and inflation expectations.
“We have different measures of wage growth, and some show an encouraging decelerating trend. But others do not. The latest available data from the Atlanta Fed’s Wage Growth Tracker show wage growth treading water at a rather elevated level,” Ms Desai said.
“In December, wages for workers switching jobs rose 7.7 per cent year-over-year, but wages for workers staying in their jobs also increased a hefty 5.3 per cent, showing that employers are having to give robust wage raises to retain workers. Overall wage growth increased 6.1 per cent.”
Citing loose financial conditions, Ms Desai said that this could turn the markets’ confidence in lower rates into a “self-defeating prophecy”.
“Markets keep testing the Fed. The Fed keeps promising that it will hike more and then keep policy tight for quite a while. Markets bet that as soon as growth weakens a bit more, the Fed will blink and start cutting rates,” she said.
“But as looser financial conditions offset part of the Fed’s tightening effort, the central bank runs a higher risk of inflation pressures becoming entrenched at an uncomfortably high level.
“This cat-and-mouse game is one reason why I think the Fed will have to raise the policy rate to 5.00 to 5.25 per cent and leave it there for the remainder of this year.”
Finally, Ms Desai said central banks are not going to see this inflation episode as a temporary aberration and that markets are misguided to believe it is.
“Just like [how] the global financial crisis (GFC) caused a long-lasting change in the attitude and stance of monetary policymakers, the inflation surge of the past couple of years will have a similar long-lasting effect,” she said.
“The GFC did not result in a new great depression. But central banks became nonetheless much more sensitive to the risk of deflation and, for the next 10 years, reacted to every shock with an overwhelming monetary easing.
“Similarly, the recent inflation surge will not result in hyperinflation or even in a 1970s-style inflation spiral, but it will make central bankers much more sensitive to the risk of entrenched higher inflation. Central bankers now understand that prolonged loose monetary policy contributed to a multi-year inflation overshoot that they have not yet brought back under control.”
Ms Desai added that markets will have to come to terms with a likely structural change in central banks’ attitudes.
“In my view, we are facing a multi-year period where markets will relearn to price risk without such a strong central bank safety net. There will be a lot more volatility — we have gotten a taste of it already,” she said.
“The silver lining is that this adjustment brings new investment opportunities, particularly in fixed income, where the focus can finally shift squarely onto the analysis-driven search for value rather than an obsessive hunt for yield at greater and greater risk.”
