Asset Management Europe: Monthly Macro Insights - March 2023

Despite cautious central bank communication about the policy outlook, particularly in view of the persistent strength of labour markets, investors were expecting rate cuts in the second half of 2023 amid a fall in global inflation. Yet, recent macroeconomic data has poured cold water on their quick disinflation sanguine view.

Will (and can) central banks tolerate stronger growth?

The February business confidence points to a return to growth, amid supply chains improvements and China's reopening from COVID lockdowns. Yet, while bottlenecks continue to fade, the output price sub-component in the manufacturing sector remains stuck at an elevated level, raising the risk of goods inflation becoming entrenched. Meanwhile, tight labour markets risk feeding price pressures in the services sector. Against this backdrop, investors were forced to revise upwards their terminal policy rate projections, while pushing out the timing of expected rate cuts.

In the US, hotter-than-anticipated CPI, PPI, and PCE inflation prints suggest inflation is likely much stickier compared to investors’ hopes. What’s more, recent US data releases brought renewed evidence of strong labour market conditions. In turn, some Fed members have floated the idea that a return to 50bps hikes could be justified, and almost all of them insisted the “higher for longer” approach was needed more than ever.

In the Eurozone, inflation was much stronger than expected in February. This could lead workers to seek larger pay rises amid a robust labour market, and thus spark a wage-price spiral, especially if inflation expectations become unanchored as the inflation is too slow to return to target. Incidentally, the ECB will hike interest rates by 50bps at the meeting on 16 March, and might have to add at least 75bps more by the end of 2023.

In sum, buoyed by hopes that the recent loosening of pandemic restrictions will feed through to improvements in the Chinese economic activity, whereas Europe’s recession fears have evaporated, investors have revised upward their global growth projections. However, central banks might very well take a negative view of the improvement in the economic outlook and, cynically to some, prevent any acceleration in global growth by tightening their monetary policies even more.

Lessons from the 1970s

The surge in consumer prices of the past two years has ignited the worry that the global economy could face a period of persistent high inflation. The commodity price surge in the wake of Russia’s invasion of Ukraine has exacerbated already elevated inflationary pressures driven by the pandemic’s supply disruptions, both in the goods sector and labour market. In that regard, the situation resembles the 1970s supply oil shocks. Furthermore, then and now, monetary and fiscal policies were accommodative in the run-up to these shocks.

However, the 1970s were a time of considerable structural economic rigidities, and general wage indexation was a powerful force in the wage-price spiral. But in the 1980s, most countries decided to stop indexation clauses as these schemes involve the risk of upward shocks to inflation lasting longer. Furthermore, there has been a paradigm shift in monetary policy frameworks since the 1970s. Today’s central banks have clear mandates for price stability, expressed as an explicit inflation target, and have established a credible track record of achieving their targets.

Overall, synchronous policy tightening around the world contributed to the global recession of 1982, with global inflation waning to around 5 per cent per year, on average, in the remainder of the 1980s, compared to more than 10 per cent a year on average between 1973-83. Thus, a key lesson from the 1970s is that central banks need to act in a pre-emptive manner to avoid a loss of confidence in their commitment to maintaining low inflation, specified today in their inflation targets. Will today’s central banks embrace this short-term pain for long-term gain?

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Completed writing on 6 March 2023

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