If there is one thing to sum up 2022, it is inflation. The scourge of rising prices engulfed nations worldwide, throwing markets into disarray and sparking the most uncertain time ecnonomically since 2008, and the first notable period of mass inflation in the Western world since the 70’s.
A combination of reasons – the pandemic choking supply chains, massive monetary stimulus, the war in Ukraine amongst others – sent prices vertical. And for the guts of the following year, the topic was the unquestioned number one in terms of market levers and column space.
Until now. In the last few months, fears of inflation have subsided, only to be replaced by a a fellow grim moniker: global recession.
Monetary policy isn’t a perfect way to deal with rising prices, but it’s the main tool that central banks. And so, up interest rates have gone.
Accordingly, liquidity has been sucked out of the system. Markets have been pulled back significantly, gasping for air following the abrupt curtailment of a decade-long bull run bred off basement-level interest rates.
It’s hard to overstate how crucial the interest rate level is to the entire economy. It defines the cost of money, which fuels everything around us. The tech sector is a stark example of this. Notorious for not making profits, the Silicon Valley cohort got by just fine off the promises of future returns, with companies commonly valued by discounting these future cash flows back to the present via (near-zero) interest rates.
Now, interest rates have risen towards 5% and these valuations have collapsed. The tech-heavy Nasdaq index printed its worst return since 2008, shedding a third of its value last year.
But the positive of all this is that inflation has begun to drop off. Helped by gas prices coming down too, the rate of price rises – according to the market, at least – appears to have peaked.
The year-on-year measure has dropped every month since last July. While the rate is still extremely elevated at 6.4% – and well north of the 2% target – it represents significant progress from the days of near double digits last summer.
Of course, this comes at a price. As we said, the interest rate defines the price of money and is vital to the entire economy. These interest rate rises come at a price.
And for inflation to truly settle, there has to be at least a little give in employment and demand. That’s how it works – slow down the economy, pull prices back down.
The labor market…is especially important for inflation in core services ex housing” said Federal Reserve chairman in November. “(It) shows only tentative signs of rebalancing, and wage growth remains well above levels that would be consistent with 2 percent inflation over time. Despite some promising developments, we have a long way to go in restoring price stability”.
And this sums up the predicament. The goal of rising interest rates is to cool down the economy and rein in inflation, but not so much that a large recession is triggered. It’s a difficult tightrope to toe. And with inflation softening, the market has begun to fear that interest rate rises have been too severe, and that a recession may be imminent (If talk of a recession gets you excited, I also recorded a podcast on the looming threat here).
The good news is that 2023 has sparked a bit of positivity, with the picture looking more optimistic than in the depths of winter last year.
China has reopened from its zero-COVID policy rapidly, a huge boost to worldwide economy and a nice easing of supply chains to boot. The price of gas in Europe has fallen like it is an obscure cryptocurrency token, while the previously mentioned inflation numbers have not been as bad as the market had anticipated.
In fact, I wrote a few weeks ago about how the IMF forecasted that the UK would be the only advanced economy to dip into recession in 2023. Now that’s not good news if you’re a Brit (I dug deep into the sorry state of the UK economy here, if you’re interested), but if this report had come out a few months prior, it likely would have forecast several more countries succumbing to the terrifying r word.
And so, the market is now in a funny spot. Bad news is good news, because that means no inflation, but not too bad, because that means recession. But without doubt, inflation has come down to such a degree that recession is now the biggest fear.
That is not to say inflation is beaten. If you scroll up to the top of this piece and look at the chart plotting inflation back in the 70’s, you will see that it fell three times, before peaking back up higher again. So we should not count our chickens before they have hatched, although that is what the market is doing. And the market always knows, right?
Whether you agree or not, the market is bored of inflation. It’s now all eyes on the threat of a recession. But at least things are looking a little rosier now than a couple of months ago.
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