Financial markets are supposed to be cool, dispassionate judges of what is to come. This week demonstrated they are just as confused as anyone else.
On Wednesday, share prices soared after U.S. Federal Reserve chair Jerome Powell reassured people that the economy was still on track for a “soft or softish landing.” A day later, after traders had time to mull his words, stocks suffered an epic selloff.
The whipsaw action wasn’t unprecedented, but it was close. Only eight times since 1970 has the S&P 500 index swung by more over a two-day period, according to Roberto Perli, head of global policy at investment bank Piper Sandler.
Behind the market’s wild mood swings lies a simple question: If push comes to shove, will central bankers choose to squash inflation by hiking interest rates? Or will they support their economies and their markets by taking it easy with further rate hikes?
Optimists hope policy-makers won’t have to choose. In an ideal world, inflation will fade over the next year as oil markets swing back into balance, pandemic stimulus fades and Russia’s war in Ukraine ends in a peace settlement or stalemate.
But if that doesn’t happen? Then we have issues.
Central banks, including the Bank of Canada and the Federal Reserve in the U.S., attempt to calibrate their policies by estimating a neutral interest rate for the economy. This is the central-bank interest rate that neither accelerates inflation nor reduces it when the economy is operating at full throttle.
Neutral rates sound reassuringly scientific. The catch, though, is that no one can actually see the neutral rate. Central bankers have to guess what the number is, based on experience and economic models. If you think this makes central bankers sound like people playing pin the tail on the donkey, you are not far wrong.
Need for monetary-policy independence will be stronger than ever in months ahead
The one thing no one disputes is that central banks are way off target at the moment. Inflation has taken them by surprise. Both the Bank of Canada and the Fed say they think the neutral rate now lies between 2 and 3 per cent. However, their policy rates are barely tickling 1 per cent.
This means interest rates must go up. Markets are braced for the Bank of Canada’s overnight rate to hit 3.25 per cent next year and for the Fed’s equivalent to touch 3.75 per cent by mid-2023.
It’s not obvious, though, that the projected rates will actually succeed in reining in runaway prices. Even if inflation in both countries were to fall by half over the next few months, it would still be running at more than 3 per cent a year. After adjusting for inflation, the projected central bank rates would be around zero in real terms. It is hard to see how such measly real rates would stop inflation in its tracks.
History suggests central banks must raise interest rates substantially above the neutral rate to quell inflation. In the 1980s, for example, central banks had to keep policy rates several percentage points above inflation for years on end – and endure a couple of painful recessions along the way – before inflation was finally brought to heel.
Granted, the 1980s were a very different time than now. Unions played a far larger role in setting wages, and their desire to offset rising prices helped feed spirals of rising wages and rising prices. Meanwhile, consumers had endured years of rising prices and fully expected high inflation would continue. Their expectations weren’t easily changed.
The economy today is much more flexible than its 1980s equivalent. Unions are less of a factor. Consumers are not yet assuming high inflation will persist. So maybe central banks will have an easier time bringing the current inflation surge under control than they did 40 years ago.
Or maybe they won’t. Lawrence Summers, the Harvard economist and former U.S. Treasury Secretary, argues the federal funds rate, the key policy rate for the U.S. central bank, will have to hit 5 per cent or more to make a meaningful difference on the inflation front.
Interest rates at that level would deliver a devastating blow to share prices and bond prices. They would also wreak havoc in the housing market. But Mr. Summers argues the alternative is even worse. Refusing to boost rates aggressively and allowing inflation to fester would doom the U.S. to stagflation – a period of both high inflation and slow growth – as well as a more painful recession down the road.
As you might expect, not everyone agrees with this bleak outlook. It is possible, for instance, that even mild rate hikes could succeed in cooling economic growth and reducing inflationary pressures, especially in Canada, where any flicker in borrowing costs feeds directly into our national real estate obsession.
Stephen Brown, senior Canada economist at Capital Economics, doubts the Bank of Canada will be able to raise its overnight rate above 2.5 per cent before falling home prices force it to back off. “Our argument is that the economy can’t actually stomach a rebound in interest rates to neutral levels,” he said in an interview.
This sounds reasonable, even if you have to worry about the longer-term prospects for an economy so dependent on a continuing flow of easy money. For now, we can still hope for a softish landing. But the emphasis is on the -ish.
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Ian McGugan