In most wealthy countries, most professionals working in real estate and financial markets only know of broadly falling interest rates in a relatively low inflation environment (and deflation for many goods). The remaining people with memories of the before times are retiring. Because during the last few decades monetary policy has also been accommodating, and asset prices have risen it has been relatively easy, for those with access to credit, to make money in such an environment. (This has had upwardly distributive effects.) Here's a chart with inflation adjusted returns on the S&P 500 (and look at how steep that curve is from 2010-2020, and even from 1980 to the present, and then look at the Y axis):
Now with inflation at forty year highs, and several rounds of interest tightening in the pipeline we may be at a dangerous inversion point. There are really two questions lurking here: first, what kind of short-term carnage will this create to all kinds of business models used to cheap money and rising asset prices not to speak of those financial institutions that never really managed to clean up their balance sheet after the Great Recession? I suspect that the (painful) answer to this question will start to become clear this Fall and next year.
Since the mid 1980s most major financial corrections have been followed by easy money by the Federal Reserve (and eventually ECB). This was made possible by incredible low inflation (see here). If inflation does not come down, the FED may be unwilling to exercise the Greenspan put when the current bear market turns into a rout. And then we will be in uncharted territory for many in the financial sector and industries built around rising asset prices.*
Yes, folks lived through the financial meltdown of 2007-2009, but the business survivors are used to cheap credit and so are the fancy systemic risk models used in all the stress testing exercises. I looked through the Basel Committee's guidance and Bank of England instructions, and the main indicator they are using is the build up of the ratio of non-government credit/GDP. The average in Europe is about 80% (with the Scandinavian countries and the UK being outliers over 140%). But in the United States it's over to 200%. (To be sure, these absolute numbers are not as informative than the change in the rate.) I saw no mention of inflation in any of the guidelines (but maybe I missed it).
The Federal reserve's stress testing scenarios do include inflation. (This makes me suspect I missed it in the European guidelines.) In all the scenarios, including the worst case modeling, inflation comes down a lot from its current rates. So, second, what if higher inflation and higher interests rates are here to stay? The natural assumption for many is that with a bit of time the effects of post-Pandemic shortages and Putin's war will play themselves out alongside the higher interest rates. Even if prices don't return to pre-pandemic levels, and Ukraine becomes the site of a long-term war of attrition, an optimistic may well believe these rates may stabilize at some point like they have done every time in the last four decades. Especially in Europe, inflation really is still mostly an effect of high energy prices. (Stateside the economy really seem to be growing above the long term trend.)
But while not unprecedented, this, too, makes some heroic assumptions. First, Putin's war means defense spending will go up structurally around the world. Second, the free trade and relative open borders era has come to an end. This already started with Brexit and the Trump's trade wars in the Anglo-heartland of free trade, but effectively Russia has been decoupled from the world economy. This last fact alone will incentivize countries outside Pax Americana (and that's about 2/3 of the world population) to build up redundancies and to become more sanction proof and less vulnerable to the world market. This is especially so for the two colossuses: China and India, both of whom are governed by political classes who view Pax Americana with considerable suspicion. And in many OECD countries, the balance of political forces may well favor nationalists over their cosmopolitan rivals. The closed door to migration will only push inflation up. And this, in turn, that is such inflation, will radicalize people living on fixed pensions and those whose retirements are dependent on inflation adjusted outsized asset price gains.
As an aside, for the world's poor countries serious inflation in food and energy prices, even if relatively short term, are a real humanitarian disaster and it may well put hundreds of millions of people at risk of starvation. They will pay the price for the failure of collective security in Europe, again, (alongside, perhaps their political elites' cozying up to Russia and China.)
Third, climate change will keep putting upward pressure on prices both due to need to finance the transition to lower carb energy sources as well as due to the investment needed to mitigate the risks associated with it and due to pressure on food prices. While it's possible there may be great technological breakthroughs that counterbalance all these effects, our best hope is still for many countries simply to continue to catch up with the labor productivity of wealthier nations by better education of the labor force.
Let me wrap up. With money cheap, during the last decade several countries have also let their debt balloon: Japan (a perennial), but especially US and Italy have government debt to GDP ratios over 140% now, and France and the United Kingdom are seeing levels of about 90-100%. Such countries may well welcome several years of moderate inflation in order to avoid insolvency. But if central banks engineer recessions to kill off inflation expectations, the political classes of those countries, especially, will have very unpleasant political choices to make. The next decade may well be turbulent and it is by no means obvious their political classes -- which in the US is nearly dysfunctional now -- are equipped to handle it.
*I personally think it wouldn't be all bad if the talented and energetic young in our society didn't all go into finance and investing, but into other professions.
Re your footnote: I think that path was more then norm in the 90's & 00's. Since then haven't all the smart kids gone into optimizing social media to keep users hooked and make sure we all get fed extremist content to keep us riled up? Pick your poison I guess.
Posted by: Oren Cheyette | 06/19/2022 at 08:11 AM