High inflation isn't the main problem
But persistently high inflation is.
I reckon that is a key distinction that needs to be made when viewing the current problems faced globally and how central banks are going to respond to that.
I've talked about the disruption to supply chains already here so I'm not going to go into too much detail on that. However, the gist of it is that this problem is arguably going to linger on for many more months through to the middle of next year at least.
Let's dissect how that ties to inflation and the supposed stagflation risks.
For one, policymakers are perhaps too optimistic about the recovery (in health terms) from the pandemic. The 'transitory' view on inflation assumes that:
- Consumption activity will switch back to be more services-focused rather than goods-focused as experienced during the pandemic
- Supply bottlenecks and disruptions will gradually ease globally as the pandemic subsides and global connectivity resumes/reopens
Those are fairly valid assumptions. However, the timeline in which it is going to take place perhaps doesn't fit with the typical "temporary" or "transient" definition.
The problem for policymakers is that there is no exact playbook to go about this but they have a reference point. And that is to look at labour market conditions.
However, even that is largely obscured at the moment considering the fact that we are seeing a relative mess when it comes to understanding the psychological impact that the pandemic is having on the workforce as we start to shift to the post-pandemic era.
The most obvious issue is that there is significant labour shortages globally and that also creates wage pressures across all points in the job market. One of the most straightforward explanations here is that there is an occupational mismatch, in which workers are in jobs which does not match with their skillset i.e. jobs are in the wrong places.
Again, all of this should ease and get better as the pandemic subsides but it will take time. I'll come back to this later and how it relates to the inflation debate.
Anyway, the fact that central banks don't have much to go on means that they can only do so much and to make things worse, their toolkit is ill-equipped to deal with the root of the problems faced by the global economy at the moment.
BOE governor Bailey's quote this week is my favourite in capturing that sentiment:
Monetary policy cannot solve supply side shocks. Monetary policy cannot produce computer chips, it cannot produce wind, it cannot produce truck drivers.
So, all they can do is respond to higher inflation and try to cool risks of stagflation but at the end of the day, perhaps they may be doing more harm than actually helping.
Now, let's take a look at the whole stagflation issue.
Global growth is slowing and likely to tail off further and inflation pressures are surging. That's a classic definition of stagflation. However, in the context of the labour market overview above, we're not going to get wage-price spirals and thus no major deanchoring of expectations, so it the big risks associated with stagflation aren't exactly in play.
Instead, what we might get is more persistent inflation - one that is likely to be volatile as it is tough to predict - in a time when the global economy faces limited growth potential.
Again, key word there being persistent.
As such, central banks are going to find it tougher by the day to keep maintaining their view that all of this is 'transitory' but they themselves know that they are not adept in dealing with the root of the problem and are just hoping that it resolves eventually.
That's not exactly a plan but it's the best one that they've got. So, what does that mean for the market and for risk assets?
In a world of persistently high and volatile inflation coupled with tepid economic growth, it paints a rather dangerous picture for risk assets especially when central banks' only response is to be more "hawkish" (even if they don't intend to be).
If the market does come to this realisation eventually, don't be surprised to see a sharper correction in equities take place - something that some quarters of the market have been waiting and calling for quite a while now.
