Dovish monetary tilts amid elevated inflation; Fed minutes signal slowdown in tightening for impact assessment | The Financial Express

Dovish monetary tilts amid elevated inflation; Fed minutes signal slowdown in tightening for impact assessment

After driving up rates by 375 basis points since March, this is a natural spot to signal a slowdown in monetary tightening for impact assessment.

Dovish monetary tilts amid elevated inflation; Fed minutes signal slowdown in tightening for impact assessment

By Madhavi Arora

Markets are hankering to see the aggressive global hiking cycle peaking. While tightening is still expected, anticipation of any slowing in the pace of hikes yields some excitement. To be sure, inflation globally on an average has peaked, the cooling is not sufficiently large or broad-based enough to bring the rate-hiking cycle to a convincing conclusion. However, that is no longer acting as an impediment to dovish turn from a number of central banks in both DMs & EMs, amid growing concerns over transmission of policy tightening to growth.

Echoing the recent shifts within DMs are the BoE, Norges Bank, BoC and RBA and the recent entrant is the US Fed. The Fed narrative is now moving towards taking stock of the cumulative tightening of monetary policy, and the lags with which monetary policy affects economic activity and inflation. The statement sounded reasonable, because any central bank would know that monetary policy works with long and variable lags.

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Monetary debates move to risk management considerations

After driving up rates by 375 basis points since March, this is a natural spot to signal a slowdown in monetary tightening for impact assessment. Essentially, the debates have now moved to risk management considerations, which is making most Central banks coming to a conclusion that while it made sense to move rapidly to restrictive territory but that now risks were increasing that they could overdo it or generate financial instability. This sentiment is likely to gradually percolate to EM central banks too.

In fact, the monetary transmission channel of super-aggressive hikes through (tighter) bank-lending now shows significant reduction recently in both demand & supply, across various loan categories in the US and Euro area. The US lending standards to corporates appreciably tightened earlier this year, with both commercial and industrial loans as well as commercial real estate loans now standing at values that typically are only seen during the early part of recession.

Well on inflation, to be fair, apart from the energy-led headline inflation easing, we are seeing the pace of core (goods) inflation moderating, albeit to levels still uncomfortably- elevated vs the target. The FOMC in its latest minutes too hinted that on inflation, there was now a little ray of optimism, as participants noted easing supply chain issues and slower rental inflation on new leases. Similarly, on labour markets, “many” noted “tentative” signs of supply coming into better balance with demand and “several” observing signs of moderation in nominal wage inflation. We think however this rebalancing of labour supply and demand would require “somewhat” of an increase in the unemployment rate.

Inflation (non)-linearity and new tolerance for central banks ahead

Overall the disinflationary impulse largely reflects unwinding of supply shocks and a higher focus on the goods sector. We reckon ongoing production constraints, esp. in the labour market, could remain an impediment on the net. But with recessions being reliable disinflationary agents, engineered by monetary policy, the inflation reversal trend may be lagged but imminent.

Our analysis suggests that the current inflation is a product of higher profit margins rather than of a conventional wage-inflation spiral – helping inflation unwind as demand eases. The inflation decline should be substantial but incomplete, as labour markets remain tight and inflation psychology has shifted. While the private sector’s underlying health and resilient demand is cushioning the economy, it will only make further over-tightening more likely, sacrifice ratios tricky, and the risk of financial cracks real.

In the medium term, the higher inflation regime is unlikely to change and may see structural shifts ahead: (1) Threat of fiscal dominance, (2) Dissipating long-term global disinflationary forces, such as (i) Globalization – reversing with a now-persistent geopolitical risk premium, exemplified by rewiring global supply chains and strategic competition, and (ii) Demographics, with an ageing population putting pressure on public finances. (3) Emergence of ‘greenflation’ emanating from climate change transition plus extreme weather events reshaping energy demand & supply, over time. Would this mean living with higher inflation if production capacity does not optimally rebound swiftly?

Rough patches not over yet

Going ahead, we envisage slower hikes ahead, which is now well telegraphed by the Fed. The December meeting will see a step down to a 50bps hike, followed by another leg of hike in Q1CY23 before they pause to stake stock. But, the superficial Fed-pivot does not enthuse us, as it fails to answer the more substantial question of how high the terminal rate will go and how long they will stay.

A substantive pivot is one that signals a different regime, like a move from hikes to a pause or from a pause to cuts. We are yet to find high-conviction answers to three interrelated macro questions: (1) How rapidly does core inflation decline? (2) What is the required extent of unemployment, for reducing wage inflation? (3) What is the terminal rate that delivers a
soft labour market and how long does it stay restrictive?

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We think the macro regime is likely to trail the 2022 stagflation in early part of 2023, entering a recession by late 2023 of unclear duration & depth, with a decent growth sacrifice to manage the inflation imbalance. But more importantly, we argue that in the medium term, the new global regime needs a new investing approach. A multi-decade period of stable growth and inflation is now over. The conventional playbook of ‘buy the dip’ or ‘time rallies’, which worked during the sustained bull markets of the ‘Great Moderation’, needs a re-watch ahead.

(Madhavi Arora is the lead economist at Emkay Global Financial Services Ltd. The views expressed are author’s own.)

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First published on: 25-11-2022 at 08:49 IST