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It was a tense moment for markets as US Fed Chair Jerome Powell took the floor to speak after the FOMC meeting last Wednesday. Monetary tightening was to be confirmed as inevitable in view of abnormally high inflation and extremely positive developments in the labour market. Yet after the falls seen since the beginning of the year, it seemed reasonable to assume that these announcements were already fully priced in and would not accelerate the collapse in markets.
The reality was very different. Following the press conference, equities collapsed (admittedly before recovering somewhat), rates rose, the dollar continued to climb versus the euro, and gold to fall. Powell’s statement was therefore a surprise, not so much because of the measures implicitly announced, but for its general tone. For once, he appeared firmly committed to containing inflation – no longer seen as temporary – and insensitive to the volatility buffeting listed assets for the last month.
Markets are gradually realising that monetary tightening will not necessarily be predictable and smooth. It will be highly dependent on economic data – Jerome Powell was very insistent on this point, possibly in an effort to make up for having minimised the gravity of inflation data for so long. Fears of major moves in monetary policy are founded, given the extent to which inflation surged in 2021 after remaining absent for years. High inflation is volatile. It creates volatility in monetary policy, which feeds back into volatility in inflation. Markets and companies are right to be troubled by this new uncertainty surrounding future developments in monetary policy.
But there is also a second area of uncertainty, which may be even tougher for markets to handle: the disappearance, or at least scaling back, of the Fed’s protection in the event of a collapse in the market or the economy. When inflation was low, too low even, a lull in the economy was not necessarily bad news for stock markets. Central banks could respond with easing measures, which gave birth to the adage, “bad news for the economy is good news for the stock market”. March 2020 was a prime example of this. This is over for now, at least for a while. Central banks have their hands tied in times of high inflation as they cannot intervene to support economic activity and markets. The exception is intervention during a crisis in defence of the idea that the slowdown is deflationary, which is not always true, as is illustrated by crises in countries with very high inflation such as Turkey and Argentina. Hence, with the current inflation scenario, the central bank parachute – called a “put” (a type of cover) in stock market jargon – no longer exists, or at least cannot be activated until we’re much lower. In the current environment, central banks are no longer the protectors of markets, until a certain level is reached.
While investors were initially happy with the relaxed attitude of central banks in response to inflation, today they are seeing the price that must be paid for this. And we don’t yet know how high the final bill will be, as the tightening currently being implemented is likely to be with us for some time. Four rate hikes of 25 basis points are expected in the US in 2022, but more than double this will be required to reach the expected point of long-term equilibrium of 2.5%. On top of this, the ECB may have to follow in the Fed’s footsteps, since it is now faced with almost the same level of runaway inflation – 5% in the eurozone according to the latest data, but much more in some countries (12% in Estonia).
Thankfully, companies and investors are adjusting. The shift in the inflation regime may be tough, but stability is being re-established, until the next change. Despite the debts, despite the doubts, this tightening may seem to be a financial task of Everest proportions, but will be without doubts just one stage in the continuous but rocky rise of markets over the long term.
Written on 28.1.2022, by Olivier de Berranger, CIO, LFDE