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It felt too good to be true and maybe it was. The Panglossian optimism that prevailed in the markets over the summer has faded thanks to perceptions of weaker growth momentum in the global economy and, more especially, in those twin engines of global growth, the US and China.
Business and consumer confidence has waned, job growth has underwhelmed, energy prices have spiked and supply bottlenecks are everywhere. That, in turn, has given rise to growing concern about inflationary pressure.
Central bankers who earlier insisted that surging inflation was purely transitory are now having second thoughts, raising the possibility that they will soon reduce the support they have been offering to a recovery that now appears to be flagging. In a delicately revisionist phrase, Andrew Bailey, governor of the Bank of England, has talked of possible circumstances in which “transience would be longer”.
Since September the result has been falling equity prices and rising bond yields. This has spelled trouble for conventional portfolios comprising 60 per cent equities and 40 per cent bonds. The change in correlation between the two asset classes means that there is no longer a rise in bond prices and fall in yields to offset the pain if equity prices fall.
That is what happened in the great stagflation of the 1970s which was also marked by spiking energy prices. It required dramatic rises in interest rates to curb soaring inflation expectations. Under Paul Volcker, the US Federal Reserve raised policy rates to close to 20 per cent in 1981. In an effort to re-anchor expectations, the Fed held rates above inflation into the new millennium.
In the early 1980s, developed world economies were much better equipped to handle abrupt increases in interest rates than they are today. Debt levels were low whereas now, because of the pandemic, global debt in 2020 jumped by 14 per cent to a record high of $226tn, having seen a big earlier surge after the financial crisis of 2007-09. That reflected the central banks’ ultra-loose monetary policy which encouraged borrowing and a bond-market bubble.
Another consequence of the Fed suppressing Treasury yields through its asset purchasing programme, highlighted by Steven Blitz of TS Lombard, is that equities have become an outsized percentage of household net worth in the US and thus have an outsized impact on discretionary consumer spending. He believes the implication is that an overvalued equity market has become a vigilante governing Fed actions.
This seems counter-intuitive. Bond market vigilantes in the 1970s imposed fiscal discipline by refusing to buy excessive issues of government debt in the primary market. An equity vigilante today would be selling shares in the secondary market to pressure central banks into monetary indiscipline.
Yet Blitz is onto something. There is no question that if the monetary authorities normalise policy, the resulting tightening of financial conditions could damage the recovery.
In its latest Global Financial Stability Report, the IMF says that there is significant uncertainty about the effect of normalisation on asset prices given the larger role central banks play in sovereign bond markets, the anticipated increase in the supply of government IOUs and diverging monetary policy cycles across countries.
If anything that understates things because of the extraordinary extent to which central banks have nationalised global securities markets. The IMF’s own figures show that monetary authorities have increased the assets held on their balance sheets to close to 60 per cent of gross domestic product, almost double the level prevailing before the pandemic.
Any reduction or reversal of the support the central banks now offer to the global economy and to markets could thus have a devastating impact. The central bankers know this and they also know that if their response to rising inflation precipitates collapsing markets and a recession it could cost them their independence.
It follows that there could be a behavioural bias towards caution and delay in tightening. Yet the lessons of monetary policy in the 1970s and 1980s were that while rising unemployment resulting from early tightening could easily be addressed by a change in policy, delay would cause inflationary expectations to become unmoored. A much tougher policy and a more serious recession were required to bring inflation under control.
Delay was in fact the response of the Fed under Arthur Burns, who insisted that the rise in oil and food prices was not a monetary phenomenon and therefore should be ignored. That was how the US arrived at a benchmark policy interest rate around 20 per cent and a horrendous recession in the early 1980s. Few now doubt that the central banks will shortly cut back their asset purchasing programmes.
Yet investors’ deep seated conviction that monetary authorities will always come to the rescue if markets tank suggests that weakness in bond and equity prices will not turn into a rout just yet. That said, we are in an unstable equilibrium. In due course something has to give.
john.plender@ft.com
