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There’s a well-known children’s tale, Chicken Little, about a young chicken who believes the sky is falling after an acorn hits her head. As such, the term “Chicken Little” is often used to describe people who stoke fear needlessly among people or believe that a catastrophe is imminent. To that end, many experts are posting daily on social media about the pending disaster that awaits if central banks don’t continue to raise interest rates aggressively.
As inflation has continued to soar, many economic pundits and central bankers have anchored their cognitive bias on the Great Inflation of the 1970s and early 1980s. They see the need to attack current inflationary pressures with swift aggressive increases to interest rates, using the same vigor as then U.S. Federal Reserve Board chairman Paul Volcker.
That’s why the Fed and the Bank of Canada, among others, have initiated the most rapid and aggressive tightening cycle in modern history. However, for many, the response was slow. While they’re correct, in hindsight, criticizing central bankers for not starting an aggressive tightening cycle during the middle of the Omicron wave that led to economic shutdowns and before Russia’s invasion of Ukraine kicked inflation into the stratosphere is harsh.
Monetary policy affects the business cycle with a lag of at least nine months; and in this modern world of instant gratification, the inflation measure the Fed anchors to monetary policy, core consumer price index (CPI), which contains many lagging price variables, has yet to respond.
The main culprit is the way real estate prices are recorded. Simply put, real estate prices, which account for almost 40 per cent of core CPI, are currently reflecting the price increases of nine months ago. Yet, according to the S&P/Case-Shiller U.S. National Home Price Index, housing prices were negative in September.
Alas, a new credibility problem has arisen. Are central bankers going to continue to raise interest rates aggressively into a highly levered dramatically slowing global economy when forward-looking, real-time data points to a dramatic decline in economic growth and inflationary pressures? All because of the flaws that exist in their old, antiquated forecasting variables?
Inflation hawks may be right but for all the wrong reasons. The Fed’s own research suggests that two-thirds of the inflation we’re now experiencing is not being caused by an overheating economy but by the twin exogenous shocks of COVID-19 and the Russia-Ukraine war.
American economist Robert Solow, formerly a professor at the Massachusetts Institute of Technology, criticized Mr. Volcker’s policies strongly in his famous expression, “It’s burning down the house to roast the pig.” Indeed, the policies used to fight the inflation of the 1970s and early 1980s, coupled with globalization and the rapid transition from an analog to digital economy, sowed the seeds for a decades’ decline in the standard of living for many workers and fuelled the rise of populism that we’ve seen in recent years.
Today, central bankers are being criticized for their actions, which many say will potentially push the global economy into a severe recession or even a major credit crisis – all because of the way rent increases are weighted and recognized. Furthermore, too many ignore Mr. Volcker also had the benefit of two decades of financial repression, reducing global debt to more manageable levels. Yet, according to International Monetary Fund data, global debt levels now stand at 256 per cent of gross domestic product, and the global economy saw the largest increase in debt in 50 years in 2020.
What’s the way forward?
As such, there are two distinct paths the Fed can take in tackling current inflationary pressures. It could continue to replicate Mr. Volcker’s familiar playbook, or it could take a more patient approach, going against the uber-hawks and representing a generational change for the central bank.
Whichever path it chooses will have differing and significant implications for investors and for central bankers’ credibility.
Central bankers have already proven their inflation-fighting credentials. Even with their flawed variables, inflation will be dramatically lower in 2023. Inflationary expectations are well anchored, as measured by the five-year breakeven rate, which currently stands at about 2.5 per cent. Real-time price data point to significant declines in many categories.
Furthermore, the wage inflation spiral so many were worried about has not materialized. And the strong economic growth generated by the fiscal policy response to the COVID-19 pandemic will slowly turn into what many economists call a “fiscal drag” next year.
Markets, left to their own devices, will adjust. The mistake and risk to central banks’ credibility now are tightening too much, grasping defeat from the jaws of victory. As Benjamin Rush, one of the founding fathers of the U.S. once wrote, “Two wrongs don’t make a right.”
In effect, central bankers are aware of these nuances in inflationary calculations and will choose the patient approach soon. The result is that 2023 will be the year when data dependency comes back in vogue.
James Thorne is chief market strategist at Wellington-Altus Private Wealth Inc. in Toronto.
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