New year, old problem
The new year began with an old foe: elevated levels of inflation globally. While growth is robust in developed economies, price pressures are acute. Consumer prices in the UK and the Eurozone have increased by around 5 percentage points this year; in the US, inflation is running at nearly 7 per cent, the highest since June of 1982.
This has left central banks, especially the US Federal Reserve, markedly reassessing its ultra-loose monetary policy for 2022: how aggressively central banks act to tame inflation represents the biggest risk for this year. This includes not just tapering off quantitative easing and raising rates but also actively seeking to shrink its balance sheet – a course of action that few analysts would have predicted just over a year ago.
In a best-case scenario, liquidity remains ample and economic momentum is strong enough to withstand higher rates.
Moreover, in terms of balance sheets, central banks at first simply stop buying new bonds and hold the bonds they already own until maturity, thereby 'running off' the balance sheet at a slow pace over time (ie effectively what the Fed did from 2014 to 2016).
Eventually, they can resume 'normal' open market operations with a bias to reducing the overall size of the balance sheet, actively selling more bonds back to the market than they buy (ie what the Fed did from 2017 to 2019). If done in an environment of sufficient economic growth, the result will likely be a healthy deleveraging, which should not destabilise markets.
In a worst-case scenario, liquidity dries up, economic momentum falters and central banks go too fast from run off to sell off (ie the European Central Bank’s experience in 2013 and 2014). Markets will likely respond to this adversely.
The actual path will likely be closer to the former than the latter. Why? Primarily because the underlying drivers of currently high inflation are not structural and are likely to ease once temporary factors are behind us – that will allow central banks to slowly tighten policy as opposed to a faster tightening.
Firstly, most of today’s apparent surge is the base effect. For example, in January 2021, the price of a barrel of Brent Crude oil was close to $50 (£38) compared with $100 now. This has been the single largest factor in currently high inflation. The conflict in the Ukraine will undoubtedly continue to put pressure on commodity prices in the short term, however few expect oil prices to double again (though admittedly it is likelier than it was a week ago).
Secondly, there were also marked shifts to our consumption patterns, with post-pandemic consumption of durable goods 34 per cent higher in real terms (at its peak) than before, as spending on services was slashed. This overwhelmed supply chains and caused the rise in prices of many weighty components in inflation indices (eg used cars). Now, after having gorged on goods in lieu of services, consumption patterns appear to be trending back to normal and supply chain blockages, while still material, are easing.
