On My Mind: The Long and Winding Road…

With inflation running at multi-decade highs, major central banks get ready to tighten monetary policy. Franklin Templeton Fixed Income Chief Investment Officer Sonal Desai argues they are well behind the curve—and why she thinks markets still underestimate the long, volatile adjustment period that lies ahead.

Investor attention is now focused on the immediate challenge that central banks face in recalibrating policy against rising inflation. That’s a crucial issue. But we should pay even more attention to the perilous multi-year adjustment process that lies ahead, during which markets will have to relearn to price risk without the central banks’ ever-present safety net.

In recent weeks the Federal Reserve (Fed), the Bank of England (BoE), and then the European Central Bank (ECB) have all surprised markets with hawkish turns in rhetoric and, in the BoE’s case, in policy. It really should not have come as such a big surprise. Supply side constraints in the global economy are proving a lot more persistent than policymakers hoped, for at least three reasons: (1) supply chain disruptions continue to plague manufacturing and distribution channels; (2) vaccines have shown limited effectiveness in curbing contagion, limiting the labor supply recovery; (3) and China’s zero-COVID policy threatens further disruptions to global supplies.

On the other side of the ledger, demand remains relatively buoyant, boosted by the lifting of COVID-19 restrictions and by generous fiscal and monetary policy support, even though high inflation is beginning to pose a headwind by eroding purchasing power.

The consequences are playing out as common sense would suggest: inflation has taken off, reaching 40-year records in the United States and Europe. With inflation so high for so long, inflation expectations have de-anchored from central banks’ targets and moved significantly higher; wage pressures have already risen in the United States and might soon do so in Europe. A monetary policy shift seems logical and is long overdue. As my colleague Nikhil Mohan points out in a forthcoming note, most macro indicators including labor market slack, wages and inflation are running considerably hotter now than when the Fed launched the 2004-2006 hiking cycle, which brought policy rates up by 425 basis points to 5.25%.

Even with this recent policy shift, reality has not fully sunk in yet. The Fed, based on its “dot plot,” expects to bring inflation back under control while keeping negative real interest rates all along. Most investors seem to agree, as markets appear to be pricing a short hiking campaign, with the fed funds policy rate peaking around 2.2% by 2023, then with rate cuts to follow by 2024. This in turn would imply that investors expect one of two scenarios: (i) a shorter economic expansion relative to any in the past four decades, or (ii) that the Fed will once again blink as long end rates move higher and step back in to support asset prices. In Europe, a significant share of market participants seems horrified by the ECB’s hawkish turn and appears to think that any rate hike this year would be an unforgivable policy mistake.