The inherent instability of the Goldilocks market consensus
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The writer is president of Queens’ College, Cambridge university and adviser to Allianz and Gramercy
It is not often that I take a very strong view that runs directly counter to the market consensus. On the rare occasions in the past that I have done so, it has been an uncomfortable feeling at first.
The question is whether my current scepticism over the consensus view of a “Goldilocks-like” scenario for markets of not-too-hot, not-too-cold conditions, moves from being an outlier to a baseline for economists and policymakers. The good thing on this one is that I will not mind if I end up being wrong as it would also mean a much lower risk of unnecessary economic and financial disruption.
As highlighted by a recent Bank of America survey, markets are currently dominated by a consensus based on three core hypotheses: durable high global growth; transitory inflation; and ever-friendly central banks.
By embracing this trifecta, investors have pushed equity and corporate bonds ever higher, anchored government bond markets, and sidelined short sellers who bet on falling prices
Notwithstanding some qualifications, I have no serious quarrel with the view that growth will be robust in the biggest economic regions in the world — China, the EU and the US.
Indeed, I am more optimistic about European growth prospects than I have been for a very long time. I also agree that the systemically important central banks will maintain ultra-loose monetary policies for quite a while. Whether warranted (in the case of the European Central Bank) or not (in the case of the US Federal Reserve), they have too much of their reputation and thinking invested in uber-stimulus to risk a premature easing of the monetary accelerator.
I do worry a great deal, however, about the widespread conviction that the current rise in inflation will be transitory. This is not because I deny the two influences on the current data will be reversed — comparisons with a low base last year and some temporary supply-demand mismatches.
Rather, it is because of all the on-the-ground evidence of structural changes in supply at a time when aggregate demand will remain robust.
This is notable in the functioning of the labour market with uncertainty over skill mismatches pushing up wages. Labour supply might also be affected by a different propensity to work coming out of the pandemic. In addition, there are ongoing changes in supply chains, inventory management and transportation.
Then there are the typical lags. Not having lived through an inflation period for quite a while, there might be too little appreciation by some investors of two historical dynamics.
First, seemingly one-off increases in prices can cascade through the system. Second, a rise in inflation can be persistent, starting with commodities and prices at the factory gate only to end up in consumer prices and wages.
To be clear, I do not expect a return to the inflation of the 1970s. But we have to respect the possibility of a shock to a financial system that has been conditioned and wired for the persistence of lower and more stable inflation.
All of which leads to another complication. Should such worries be borne out over the next few quarters — and it will take time as central banks are likely to extend the time period that defines “transitory” — that would raise doubts about the other two elements of the market consensus on high growth and friendly central banks.
With the Fed having switched its approach on monetary policy to being dependent on outcomes in economic data rather than the traditional forecast-based approach, it is likely to be very late in adjusting strategy should its transitory inflation call not materialise.
A late slamming of the brakes, rather than an earlier easing off the accelerator, would significantly increase the risk of an unnecessary economic recession.
Indeed, that is the strong cautionary message that emerges from even the most cursory reading of the history of modern central banking policy mistakes. It also risks unsettling financial stability, undermining growth further. And that is if market accidents do not precede the policy mistake.
Central banks’ often repeated assertion that inflation will be “transitory” is sidelining much needed exploration of what is happening to both price dynamics and the functioning of the labour market. The result is a comforting equilibrium with underpinnings that become increasingly unstable.
With that comes an increasing risk of instability down the road, exposing us all to significant economic and financial damage — damage that, fortunately, can still be avoided if both central banks and markets widen their perspective.
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