The war on inflation

If you’re tired of reading about inflation, interest rates and central banks, we have some bad news for you. It remains front and centre to the market outlook for the foreseeable future.

To paraphrase Leon Trotsky’s famous (but incorrectly attributed) comment about war: you might not be interested in inflation, but inflation is interested in you.

After two decades of low and stable core inflation in developed countries, inflation exploded higher in 2021. Central banks were initially uncertain how to respond. It appeared that inflation was due to pandemic-related supply disruptions, and monetary policy cannot improve supply. It cannot drive trucks, pump oil, grow wheat or stack shelves. However, by the start of this year, it was clear that there was a strong demand-led element to inflation in rich countries. And as the year has progressed, this has become much more evident as services inflation continues to rise, while many supply chains are increasingly unclogging. Managing demand is a familiar battlefield for central banks. The way to lower demand is to raise interest rates, and they’ve done so aggressively this year.

The most important central bank is the US Federal Reserve (the Fed) since the US dollar is by far the dominant currency in global banking, trade, and financial markets. It hiked its policy rate range by 75 basis points to 3.7% to 4% last week, from near-zero levels at the start of the year. This was widely expected so the question investors are grappling with is whereto next? The Fed will probably slow the pace of hiking to 50 and then 25 basis points increments, but more important is where rates will settle and how long they will stay there.

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