A Sticky Situation for Investors

Written by: Kevin McCreadie, CFA®, MBA | AGF

Are you surprised that inflation has started to creep higher again in countries like the United States and Canada?

We’ve said consistently over the past year that getting inflation to fall from the highs of last year to its current levels would be the easy part of the job for central bankers, but also that getting it to fall further from here would be a lot more difficult for them and not without volatility along the way.  

The reason for this stickiness, which has led to the recent uptick in inflation, stems from several factors including what’s known as the “base effect” from comparing the prices of certain goods and services today with their levels a year ago. Gasoline prices, for instance, have risen from this time last year because oil prices have rebounded following OPEC’s recent announcement of production cuts. Meanwhile, other factors are persistently high food prices and the fact that wages continue to grow at a pace that could drive the overall inflation rate still higher in the coming months, albeit not dramatically. It’s very unlikely that price levels rise anywhere close to the highs of last year.   

What are the market implications of inflation staying sticky?

It will have an obvious influence on monetary policy going forward, which, in turn could impact the direction of financial markets. This is especially true now that central banks like the U.S. Federal Reserve (Fed) have said their decisions regarding interest rates will be data dependent. In other words, if inflation stays elevated near current levels, and doesn’t soon fall to the target level of 2%, the Fed may be inclined to raise rates further.

But that may not be the biggest risk. After all, one or two more rate hikes of 25 basis points is minor compared to how much interest rates have climbed already this cycle. The bigger concern is that a protracted fight against inflation could end up keeping the Fed from cutting rates even if the economy falls into recession. Remember, that’s not how it usually works. In the past, rate cuts have generally been an automatic response to a recession and it’s difficult to know how markets would react if that ended up not being the case this time around.

Haven’t central bankers always been data dependent?

Central banks always depend on data to assess economic progress against expectations, but now they’re limiting their use of forward guidance and choosing to make policy decisions on a more ad hoc “meeting by meeting” basis that is influenced entirely by the most recent numbers that have rolled in.  

Of course, in doing so, the Fed and their counterparts like the European Central Bank (ECB) have given themselves more flexibility to act in the face of unanticipated developments than would otherwise be the case had they maintained a policy of explicit forward guidance. But it also means that central banks are potentially less clear in their communication to markets, which could result in more uncertainty and volatility as investors grapple with what to expect from policy makers going forward.

What data are central banks most focused on “meeting by meeting?”

They haven’t explicitly stated what economic indicators or sentiment readings they are paying attention to the most, but inflation gauges must be at the top of the list, likely followed by labour statistics, which, in the U.S., includes the monthly release of the country’s unemployment rate as well as weekly jobless claims, reports on job openings and any other indicators of labour market strength (or weakness) they see as relevant. Beyond that, retail sales and measures of consumer confidence are no doubt also a focus, as are things like commodity prices that can affect the strength of the economy over time.

Of course, many of these statistics are backward looking, meaning they’ve already happened and may not be indicative of the economic reality that exists on the day of their release. Moreover, these same data points are often subject to multiple revisions and can’t always be relied upon until months later.

That’s not to say central banks are wrong about their new data-dependent approach, but there’s no guarantee that they’ll interpret the incoming information correctly and a misread of the numbers could lead to a policy mistake that has potential ramifications for investors.

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