Inflationary forces (and microbial soups)

The hold of central banks over inflation may be weaker than we thought

Received wisdom – from the most mundane fields to the more complex – has a habit of coming undone. Nowadays, red wine and chocolate are good for you; cutting calories no longer holds the key to losing weight.

In the arcane world of macroeconomics, central banks’ mastery of inflation looks like an orthodoxy that’s fraying too.

The conventional view is that inflation was tamed by Federal Reserve chairman Paul Volcker and his fellow inflation hawks in the 1980s and then domesticated by central bankers armed with clearly spelled out targets and bank independence in the 1990s.

Things don’t seem quite so simple any more. Inflation defied central bank forecasts in 2022, nearing or exceeding 10% in the EU, UK and US.

Doubts are now growing among investors about whether central bankers really have the grip they thought they did.

The chatter is that decades of low inflation may have been as much a product of circumstances as the result of clear policy and communication from the Fed and others.

In recent months inflation in developed countries has started to fall. But if the doubts are well-founded, the broader outlook could remain patchy.

Geopolitical stability, globalisation, technological innovation and demographic trends all helped keep inflation low in the 2010s. The contribution to inflation from goods, as opposed to services, in the US was effectively zero for a decade up to 2022.

But several of those helpful forces are now in reverse.

The pandemic and Ukraine war have reawakened concerns about security and thrown globalisation through a 180-degree turn.

Labour participation rates are stalling across developed markets and some think the experience of the Covid-19 pandemic may discourage workers from crossing borders for employment as readily in future. And the kind of market efficiencies brought by technological innovation – such as better price discovery through the internet – may have run their course.

Shifts elsewhere take the form of new developments rather than reversals but could be just as critical. The greening of the world economy brings a new inflationary dynamic. By definition, switching to new cleaner technologies comes at a cost. Getting to net zero carbon emissions by 2050 will require $3.5 trillion a year in extra spending, the consultancy McKinsey says.

And the rise of political populism has only added more fuel to the fire, with governments increasingly pushing companies to reverse offshoring and erecting barriers to the free movement of goods and workers.

Central banks with dual mandates must also balance inflation control with employment. With a more populist political backdrop, employment may come to dominate such determinations.

Should inflation prove harder to control in future, investors will have many reasons to fret. Chief among them is the fading hope that central banks will – or would even be able to – act when markets slide.

Now is the first time in 35 years that policy-makers have been constrained from doing whatever they want, says Benjamin Bowler, head of equity derivatives research at Bank of America.

The Bank of England’s response to last year’s gilt crisis gave a taste of what’s to come, Bowler says. In the face of collapsing prices, the central bank promised to do whatever it took to restore market stability – but only for 10 days.

That was a “bit of an oxymoron”, Bowler says, and reflects the bind central bankers find themselves in. Markets are fragile but benign inflation no longer offers them a free hand to act as they please.

Away from finance, in the field of dietary science, new research says an array of diseases – and even obesity – could be caused by the balance of a person’s microbiome – the bacterial soup alive in the guts of each one of us.

Might inflation similarly reflect a tilt in environmental forces – and more so than markets previously thought? Some think it does. And the soup of inflationary drivers is changing.

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