Governor of the Bank of Canada Tiff Macklem speaks during a videoconference event with the Council on Foreign Relations at the Bank of Canada in Ottawa on Oct. 7.Justin Tang/The Canadian Press
The best advice for investors in 2022? Be prepared to change your mind.
Over the past 20 months, the most devastating pandemic in a century has resulted in the most powerful blast of economic stimulus since the Second World War, leading to the biggest inflationary shock in a generation and the most expensive U.S. stock market in more than 20 years. The result is a financial landscape that is anything but normal.
In the past, periods of exuberant share prices or rising inflation always reverted to more humdrum levels, often because central banks hiked interest rates to force them back into line. But getting back to normality will be particularly challenging this time around because it is not at all clear how the coronavirus will evolve in 2022 or how policy makers should proceed in restoring the usual order of things.
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Consider, for instance, central banks’ easy-money policies. In both Canada and the United States, policy rates are near zero. Real interest rates – that is, interest rates after inflation – are well below zero. You have to go all the way back to the mid-1970s to find any similar period of deeply negative real rates.
Easy money has been key to supporting a locked-down economy over the past year and a half. However, it has also fuelled a buying frenzy among Canadian real estate investors and helped propel U.S. share prices to mountainous heights.
It seems obvious this speculative fever can’t go on forever without risking market instability. The question is how quickly to wean the economy off its addiction to easy money. Since surging inflation has been a key factor in driving real rates so low, the answer depends in large part upon your view of what is driving inflation and how long it is likely to last.
People who argue the current surge is just a passing phase – Team Transitory, as they’ve been dubbed – have taken it on the chin in recent weeks as price gauges have continued to soar. Their opponents – call them Team Persistent – have rushed to declare victory.
Major central banks, though, aren’t yet sounding alarmed. They are starting to pull back some of their bond-buying programs and, in the case of the Bank of England, edge up interest rates, but none of the big players is yet hiking rates with gusto. Most central bankers seem understandably wary of removing too much support from economies that are still under siege from COVID-19.
Their measured approach makes sense if you consider the unusual nature of the recent inflationary surge. Unlike past periods of red-hot price increases, much of today’s inflation is surprisingly lopsided. Durable goods have shot upward in price while inflation in services has shown little change from its prepandemic trend.
This disparity is hard to square with theories that blame inflation on overly generous government stipends or too much money creation. If either were the root problem, all prices should be rising and inflation in services should be soaring more or less in line with inflation in durable goods. That was what happened in the high-inflation 1970s.
The easiest way to explain why things are different today is to state the obvious – the pandemic has been a weird time. Lockdowns forced consumers to suddenly shift their buying from services to goods. Practically overnight, families stopped dining out in restaurants, pumping iron at the gym and going on vacation. Instead, they ordered new stoves, new exercise bikes and a myriad of other diversions for their new stay-at-home lives. No wonder this unexpected wave of demand propelled durable-goods prices to unheard-of heights.
If the pandemic eases in 2022 and consumers go back to more normal spending patterns, price pressures could quickly fade away. But that is a hope, not a certainty.
Some smart people think things could go the other way. Jon Steinsson, a prominent macroeconomist at the University of California, Berkeley, is among those who worry inflation could prove persistent.
In a recent discussion with former Federal Reserve economist Claudia Sahm, Prof. Steinsson argued demand is likely to stay elevated over the coming year because of sky-high asset prices and ample levels of household savings. Meanwhile, supply will remain constrained because of people’s reluctance to return to the work force while the virus remains a threat.
Prof. Steinsson says the Federal Reserve will have to act more aggressively than markets expect to tame inflation. He would like the Fed to start hiking rates in March and be prepared to take the federal funds rate, now near zero, all the way up to 2.5 per cent over the following year or so.
A hiking cycle of that magnitude would deliver a gut punch to asset prices round the world. But here is where things get even more uncertain. As Prof. Steinsson emphasizes, the Fed should adjust its policy in the light of incoming data. In other words, the Fed should be prepared to ease back if Team Transitory is right after all and inflation fades quickly in the second half of next year. If so, any rate hikes could wind up being relatively modest and so could any impact on asset prices.
Investors should keep an open mind. Whether you are on Team Transitory or on Team Persistent, be prepared to switch jerseys.
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Ian McGugan