Inflation: Looking beyond forecasts

In my previous piece last fortnight, I had said “the probability that inflation will come down on its own is low. This means if the central banks act harshly now, the markets will crash and then rally. If they are hesitant, the pain will be prolonged”. Well, on June 10, it was announced that US inflation, at 8.6 per cent in May, was at a 40-year high, causing markets in the US as well as India to crash. On June 15, the US Federal Reserve hiked the interest rate by as much as 75 basis points at one go but the hike did not generate the required confidence that inflation in the US would be easily tamed. The markets continued to decline. Investors are perhaps finally beginning to realise that this turbulent phase may be quite prolonged.

Central banks don’t react in panic to just one piece of data. But they do react to the possibility of persistent or entrenched inflation. The Fed appears to think that inflation is getting persistent when it said, “The committee is moving rates up expeditiously to more normal levels, and we came to the view that we’d like to do a little more front-end loading on that.” The Fed may call it front-loading, but others think it is behind the curve. In a sense, it is guaranteed that there will be a series of hikes and fairly large ones at that. The fact is the federal funds rate, even after this hike, remains at 1.6 per cent when inflation is 8.6 per cent. What does it mean for us? Whether rising interest rates will curb US inflation, especially caused by the supply shock, is not clear. But there is a strong inverse correlation between rising rates and emerging markets.

With that as the backdrop, the consensus is this: Inflation will remain high, the Fed will keep hiking interest rates, and emerging markets will remain under pressure. And yet, we simply don’t know enough even today. How much of the inflation was due to the 0 per cent rate, $5 trillion in bond purchases, and $7 trillion in national debt — all caused by the Fed and successive US governments? To deal with the shock of the pandemic, the US made stimulus payments of up to $1,200 directly to every citizen; small businesses could borrow money at very low rates, and unemployed citizens were paid $600 per week. If that is being unwound, what will be its impact on demand? How much of the inflation is due to China’s lockdown and the Russian war with Ukraine, which has disrupted supply chains and led to high energy and food prices? No one, not even the central banks, has exact answers. And yet, there has emerged a widespread consensus about rising inflation and rising interest rates leading to falling markets. Remember, markets have a way of disappointing a strong consensus.

The forecasting business

We repeatedly fail to make correct forecasts about complex macroeconomic events and never seem to learn from experience. Two years ago, when the pandemic hit the world, there was a consensus about economic doom. With movements of people and goods across the country completely stopped, it was expected that output would shrink, unemployment would be sky-high, and a recession would be inevitable. That was the popular consensus and it was hopelessly wrong. Do you hear people talking about BRICS any more? In 2003, Brazil, Russia, India, China, and South Africa were touted as the new economic superpowers. Only China lived up to its promise. In 2007, the world was gripped by the “Peak Oil” theory and perpetually rising oil prices. It turned out to be false. Oil, like any other commodity, rises and falls simply on demand and supply. In 2009-10 a double-dip recession was considered inevitable after the global financial crisis of 2008. It did not happen.

When the Fed kept the interest rates low for a prolonged period after the 2008 crash, Ray Dalio, founder of the world’s largest hedge fund, feared hyperinflation and his team was reading up about the German economy and markets in the post-World War I period, when that country suffered hyperinflation. In 2011, Portugal, Ireland, Italy, Greece, and Spain (PIIGS countries) all seemed headed for insolvency. It did not happen. We do not know whether the current consensus about inflation will also be wrong but the more widespread the consensus the more likely it is to fail.

Meanwhile, macroeconomic conditions will continue to unfold in our lives with a lot of twists and turns. Last week, oil and natural gas prices fell sharply, which ought to boost sentiment this week. As we navigate the choppy waters, there will be several such periods of relief when the tide would seem to turn for the better. If the central bank fears a sharp demand slowdown, it may pause its rate hikes, which would fire up stock prices again. Finally, stock markets often presage actual improvement in economic conditions while the reported economic data invariably captures the past. It may be worthwhile to pay attention to what the markets are telling us, as they did during the pandemic, rather than rely on consensus forecasts.

The writer is the editor of www.moneylife.in

Twitter: @Moneylifers