The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy.
For years, financial markets benefited enormously from the largesse of monetary policy in a global economy that central banks, and the US Federal Reserve in particular, viewed as lacking sufficient aggregate demand.
To the detriment of the markets, this has been rapidly changing as central banks belatedly recognize that the current problem is not weak demand but rather insufficient supply. Looking ahead, an even more complicated possibility looms: that of stagnant demand amid persistent supply disruptions.
Central banks felt compelled to maintain ultra-loose monetary policy in a world of subdued economic growth and risks of deflation. The Fed went further and, in August 2020, switched to a new monetary framework that postponed the usual policy response to inflation approaching and exceeding the Fed’s 2 percent target.
For the markets, this translated into abundant liquidity. The rise in asset prices due to ultra-low interest rates was fueled by the regular injection of funds by the Federal Reserve through massive, predictable and price-insensitive asset purchases.
All this has been coming to an end due to the threat to economic well-being posed by high and persistent inflation. The cause has been the dramatic shift in the macroeconomic paradigm to one in which damaged supply, mainly due to supply chain disruptions and tight labor markets, has lagged far behind overstimulated demand.
In such a world, the Fed has no choice but to take its foot off the stimulus accelerator. And since it’s too late to do so, it will need to move aggressively to slam on the brakes, including through “front-load” rate increases, as it simultaneously begins to whittle down an inflated balance sheet that’s expanded to a staggering $9 trillion. The recession risk associated with this is unsettling.
Unsurprisingly, markets have not enjoyed the Fed’s shift in focus, as illustrated by the sell-off in stocks and other risky assets, including the 13.3 percent drop in April alone for growth stocks. more sensitive to Nasdaq interest rates.
This regime change has been made even more painful for investors by the breakdown of traditional “safe havens” as government bond prices fall and the real yield on cash holdings falls deep into negative territory due to the US inflation of 8.5 percent.
So far, fortunately, the rise in inflation has not been accompanied by a significant worsening of credit risk or major problems in the functioning of the markets. However, this could well change if the lawsuit fails. The “stagflation” (lower growth and high inflation) outlook is already moving from a risk scenario to a “baseline” scenario for several reasons.
The US is facing an accelerating erosion of the monetary and fiscal drivers of growth and financial asset valuations. Policymakers will need a rare combination of skill, luck and timing to smooth out an economy and markets hamstrung by levels of policy stimulus that were once unthinkable.
Meanwhile, household confidence and purchasing power are being eroded by inflation at a time when the high level of savings fueled by stimulus programs is drying up.
External headwinds are also a concern. China’s stubborn adherence to a “zero-Covid” policy amid the highly infectious Omicron variant is undermining its global supply and demand roles. Europe is also slowing down and could well slip into recession if there were a major gas supply disruption due to the war in Ukraine. Meanwhile, several commodity-importing developing countries face a disturbing combination of high food and energy prices, supply uncertainties, tighter financial conditions and an appreciating dollar.
The stronger these headwinds, the greater the risk of a general financial deleveraging affecting the functioning of the markets. Corporate earnings and labor market strength will be key for investors to watch for trade-offs from these trends.
The good news is that after years of massive distortions, financial markets are correcting to levels where there is more sustainable value. There is also the prospect of the restoration of more traditional correlations in the markets. That will reinforce the risk-mitigating features of diversified investment portfolios.
The bad news is that the transition from the previous paradigm of central bank policies is not complete. With the possible coincidence of complications in both demand and supply, the markets are likely to remain volatile for investors and more worrying for the real economy.