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Are investors ignoring the time lag in monetary policy?

Investors, constantly surprised by the strength of inflation in recent months, appear to be forgetting the time lag between a monetary policy action and its impact on the economy. Since the Federal Reserve began hiking rates in March 2022, and the European Central Bank in July, the monetary squeeze might only start to bite later this year or even next year.

Analogue hanging clock Source: Getty Images

History suggests resilient inflation should not surprise

Global equities have fallen into a pattern in recent months, rising strongly on hopes that the rate-hiking cycle might be coming to an end, only to fall back as economic activity and/or inflation data prove more resilient than expected. That was certainly the case in February. Having surged upwards in January, equities tumbled the following month. The trigger? A report showing that a closely watched gauge of inflation, the consumer price index, surged 0.5% from December to January – five times the increase seen in the previous month. Moreover, Federal Reserve (Fed) Chairman Jerome Powell warned that the process of disinflation has a long way to go, and further rate hikes are likely to be needed, especially if economic data remains buoyant.

Is it possible that investors, in their eagerness to see inflation quelled, are forgetting a basic rule taught to economics undergraduates? Namely, it takes around 12 to 24 months for a change in monetary policy to have an impact on the economy. Over the past year, for example, the Federal Reserve has raised rates by 450 basis points (bps), and yet the economic data so far in 2023 shows a booming labour market, strong consumer spending growth and higher-than-expected inflation.

History, as well as the academic textbooks, suggests inflation may not begin to ebb until at least the second half of 2023. Between June 2004 and June 2006, for example, the Federal Reserve hiked rates by 425 bps, but it wasn’t until December 2007 – a year and a half after the end of the tightening cycle – that the economy officially went into recession. Tightening cycles in 1989 and 2000 also took around one year to send the economy into recession.1

Are investors also underestimating how quickly inflation could ease?

As Institutional Investor points out, the time lag between monetary policy changes and their impact on the economy can prove challenging for investors and policymakers alike. For there is also a risk that the central banks could overtighten and that investors might underestimate how quickly inflation – and economic activity – could fall later this year and next.

There are already signs that inflationary pressures are ebbing. Critically, the current spike in inflation began when global supply chains came under pressure after the Covid-19 lockdowns were lifted. Now, not only have supply chains normalised, but supply pressures around the world have fallen below normal, according to the New York Fed’s Global Supply Chain Pressure Index. Bloomberg reported in March that less shipping congestion, an easing of parts shortages and weaker consumer demand had pulled the indicator lower in seven of the past ten months.2

Figure 1: The NY Fed’s Global Supply Chain Pressure Index fell below normal in February

Global supply chain pressure index Source: Bloomberg
Global supply chain pressure index Source: Bloomberg

Moreover, high inflation has not triggered a wage-price spiral in the advanced economies and monetary tightening has contained inflation expectations. In the US, for example, wage growth remains subdued and is slowing – to a three-month annualised pace of 3.6% in February, from a 4.4% rate in January.3 That’s well below the annual pace of inflation, which hit 5% in February.4

Wage pressures have picked up in Europe, but they’re still rising at a relatively slow pace – increasing by 5.7% in February,5 compared with an annual inflation rate of 8.5% in the same month. Moreover, the European Central Bank (ECB) has pointed out that ‘most measures of longer-term inflation expectations (a key influence on wage demands) currently stand at around two per cent’.6 Indeed, inflation expectations are falling around the world, according to the IMF.

Figure 2: Inflation expectations are falling around the globe

Inflation in the EU, US and emerging markets chart Source: IMF
Inflation in the EU, US and emerging markets chart Source: IMF

Volatility creates opportunities

The renowned economist John Kenneth Galbraith once quipped that ‘the only function of economic forecasting is to make astrology look respectable’. But an already difficult task is made even more challenging when one of the few certainties in economics is ignored: that monetary policy takes time to have an effect in the real world. That suggests that markets will continue to underestimate both the strength of inflation in the first half of 2023 and its likely decline in the final six months of the year. The resulting volatility could prove highly profitable.

1 https://www.institutionalinvestor.com/article/b8xnrh1t36d92l/Beware-of-Time-Lag-in-Monetary-Policy
2 https://www.bloomberg.com/news/articles/2023-03-06/ny-fed-says-supply-chains-are-back-to-normal-after-three-rocky-years?srnd=fixed-income
3 https://www.reuters.com/world/us/us-job-growth-beats-expectations-february-wages-rise-moderately-2023-03-10/
4 https://www.reuters.com/markets/us/persistent-inflation-sharpens-feds-interest-rate-dilemma-2023-03-14/
5 https://www.ft.com/content/8d795789-59be-45da-aa6a-28a67daaf299
6 https://www.ecb.europa.eu/press/pressconf/2023/html/ecb.is230316~6c10b087b5.en.html

Publication date: 2023-05-25T06:50:05+0100

The information in this presentation does not contain (and should not be construed as containing) personal financial or investment advice or other recommendation, or an offer of, or solicitation for, a transaction in any financial instrument. No representation or warranty is given as to the accuracy or completeness of the above information. Consequently, any person acting on it does so entirely at his or her own risk. The information does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. IG Australia Pty Ltd ABN 93 096 585 410, AFSL 515106.

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