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Do central banks risk ‘keeping at it’ for too long?

13 December 2023 Sahil Mahtani, Strategist at Ninety One
Sahil Mahtani

Sahil Mahtani

Throughout history, inflationary episodes have been rare. It has therefore been difficult for investors and policy makers to draw parallels of today’s experience to history.

The most often cited comparison is the experience of the 1970s and 1980s. Indeed, policy makers of the major central banks have often cited a determination to avoid the mistakes of this period, notably the Arthur Burns’ Fed, blamed with keeping policy too loose in the face of high inflation. Rather, they have invoked the spirit of Paul Volcker; the now legendary Federal Reserve Chair tasked by President Carter with slaying the inflation demons through his persistently restrictive monetary policies of the 1980s.

Current Chair, Jerome Powell used both his 2022 and 2023 keynote speeches at the Jackson Hole Symposium to reference the revered governor’s autobiography ‘keeping at it’, noting the central bank “must keep at it until the job is done”, cautioning “strongly against prematurely loosening policy”. This message continues to be presented today and is echoed across the major central banks. However, with monetary policy significantly tight across developed markets and clear signs that inflation is already falling rapidly, is there a risk that policy makers are ‘keeping at it’ for too long?

Significant progress has already been made by central banks in reaching their inflation goals. US headline inflation has fallen from a peak of 9.1% to close to 3%, whilst inflation in Europe has fallen from a peak of 10.6% to 2.4%. Initially driven by a fall in energy prices, the recent falls have been broader. Inflation of core goods prices, which encompasses items such as autos, household goods and appliances, has come off significantly, with weakness in demand, a reopening of supply chains and overstocking from business, all leading to goods price inflation collapsing to below the 2% inflation targets in both Europe and the US. We expect to see these prices move into deflation in the coming months.

In contrast, for much of the last 12 months the service sector has been experiencing the strongest inflation, boosted by pent-up demand for those things we all missed during Covid; eating out, hotels and travel. As a result, the current run rate suggests that service prices are 5% higher than they were this time last year. However, a look under the surface of this headline show there are signs that significant progress is being made here too. Indeed, if current monthly outcomes were to persist going forward, they would be consistent with service prices at the 2% target next year. If correct, this softening in service price inflation, alongside persistent weakness in goods prices, could conceivably see inflation at or even below target by the end of 2024.

This all suggests that central banks’ restrictive policies are already having a broad disinflationary effect on the economy, particularly through weakening demand driven by significantly higher borrowing costs. At the same time, the forcefulness of their actions has kept inflation expectations well anchored, a big difference to the experience of the 1970s and 80s. It is also important to remember that there are lags from their policy actions, and much of the policy tightening implemented this year has yet to be felt across all sectors of the economy. If demand were to weaken more substantially, and specifically if this led to a broader deterioration in labour markets, the inflation outcome could be even weaker than that expressed here. Indeed, it is possible we could even face a period of deflation. Despite this clear risk, central banks remain reticent to declare victory, call the all-clear and take a forward-looking approach, as they remain much chastised by their assessment that inflation was ‘transitory’ in 2021.

In this context, the economic history of WWII and its aftermath may prove useful as it shares several similarities with the war on Covid. In both cases, there was a massive fiscal expansion and large-scale quantitative easing from the Federal Reserve. With supply chains disrupted and demand bottled up, inflation rose from 2% to 20% in 1946-47 and was quickly met with contractionary monetary and fiscal policy for a prolonged period. This weakened demand and as supply chains normalised again, this led to a rapid fall in inflation. With policy kept tight despite this, prices were driven even lower, and ended in deflation in 1949. It is entirely possible that markets will find themselves facing a similar deflationary shock in 2024.

With policy makers focus on realised inflation outcomes, and purposely playing it safe by failing to account for lagged impact of their policy tightening on future inflation, there is a clear risk that unlike making the mistake of the 1970s, they risk making the mistakes of the 1940s and risk ‘keeping at it’ for too long.

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