Chronicle: Inflation beaten? ‘Team Transitory’ reappears

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An illustration of U.S. dollars, Swiss francs, pounds sterling and euros banknotes, taken in Warsaw January 26, 2011. REUTERS/Kacper Pempel/File Photo

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LONDON, Aug 3 (Reuters) – The post-pandemic inflation spurt has clearly persisted too long for central banks to ignore – but investors skeptical of a multi-year regime change or paradigm shift are always feel emboldened.

After a deadly start to the year, global markets paused in July.

Some relief may have been due after February’s Ukraine-related energy and food price shocks aggravated a post-pandemic inflation spike and forced months of dramatic revaluation of interest rates. interest, bonds and stock markets.

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The kind of synchronized tightening of monetary policy that investors are bracing for – described by the International Monetary Fund last week as “historically unprecedented” – is now well underway and fears of recession are growing as economic forecasts are reduced to the decrease. Read more

Rates markets are already looking over the hump and despite all the ferocity of central banks, the worst of the episode may be over – even if visibility is limited for policymakers and investors.

Futures markets are now seeing US Federal Reserve policy rates peak at the start of the year at around 3.35% – about a full percentage point above current rates, but also some 65 basis points below the place where they saw the so-called “terminal rate” in mid-June and now occurring three months earlier than expected at the time.

Equally significantly, they predict about half a point of rate cuts by 2023.

Slightly exaggerated by this week’s US-China tensions over Taiwan, US 10-year Treasury yields have fallen nearly a full percentage point in just six weeks to 2.51%, while yields adjusted for inflation have returned to zero. The inversion of the 2-10 year yield curve, often cited as the most accurate harbinger of recession, has deepened the most since the dot.com recession around the turn of the century.

And significantly, market inflation expectations captured in five- and 10-year pegged bonds are now both solidly back below 3% – the latter below 2.5%. Additionally, Brent crude oil prices – down nearly 30% from March highs – have eased back below $100 a barrel this week and wheat futures have returned to lows. before the Ukrainian invasion as ships resumed Ukrainian grain deliveries this week.

While recessionary prices and monetary policy compression may explain much of this, die-hard fans of the much-criticized “transitional” inflation thesis – abandoned by the Fed and other central banks at the end from last year – believe the latest twist underscores how the post-pandemic situation the surge in inflation remains primarily a supply shock that will eventually normalize.

Aggregate demand in the economy will prove little different when these distortions disappear and the pandemic’s super-easy monetary settings are removed, they argue.

In a presentation to the G20 last month, Bank for International Settlements economist Hyun Song Shin reinforced the message of the supply shock by showing how inflation surged even as real GDP rebounded in the developed and emerging economies remained well below the pre-pandemic five-year level. orient yourself.

“The charts … reinforce the message that the recent surge in inflation is not simply a story of excess demand that overwhelmed the economy’s pre-pandemic trend supply,” he wrote. “Rather, it’s a case of reduced supply capacity that hasn’t kept pace with the trend recovery.”

BIS Charts on Global GDP Underlying Trend
IMF charts of inflation projections
Fed funds futures and the 2-10 year yield curve

UNDER POTENTIAL

Quoting that speech, hedge fund manager Stephen Jen of Eurizon SLJ said it seemed odd that the consensus now believed that an even wider output gap was now needed as inflation would decline anyway over the course of the year. coming quarters as global supply normalizes.

“There doesn’t appear to be enough appreciation that the global economy is still operating at levels significantly below historical potential,” he said.

“My own hypothesis is that over time much of the inflation now plaguing the world will end up being ‘transitory’… driven by supply factors that are not permanent, beyond the control of central banks and will most likely not contaminate long-term inflation expectations.”

For Jen, a myriad of arguments for a new era of rising inflation — from shifting geopolitics, “de-globalization,” and supply chain overhauls to aging population, tight labor markets and an energy transition – were mostly brought together after the surge in inflation and remain unproven at best as long-term enduring factors. Read more

But if inflation does come down over the next few quarters, he says higher stocks, lower bond yields and a slightly weaker dollar will be the result.

While other investors sympathize with this view, they believe the uncertainties are simply too great in the midst of a tightening cycle to bet the farm on either outcome just yet. And many asset managers seem reluctant to jump on the July rally.

“We lean more towards mitigating the rally in risk assets than continuing it,” said Paul O’Connor, head of Multi-Asset at Janus Henderson Investors. “We can see a higher fundamental trajectory for risk assets from here, but it’s narrow.”

The problem for anyone trying to solve this problem is that even if you think this surge in inflation is only due to temporary supply distortions, unpredictable political calculations make it impossible to resolve with certainty. And converts to the idea of ​​a “new paradigm” believe that the longer these distortions persist, the more entrenched inflation expectations will become anyway.

Energy, food and supply chain biases related to tensions over Ukraine or the deterioration of relations between Washington and Beijing over Taiwan – not to mention the outcome of the November US Congressional midterm elections – mean that guesswork more than belief will likely dominate the rest of the year.

Asset price rebound in July
Central Bank policy rates
inflation pulse

The author is Finance and Markets Editor at Reuters News. All opinions expressed here are his own.

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by Mike Dolan, Twitter: @ReutersMikeD; Editing by Josie Kao

Our standards: The Thomson Reuters Trust Principles.

The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and non-partisanship by principles of trust.

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