Last week we discussed the continued focus of Developed Market Central Banks on the prospect of continued above trend or ‘sticky’ inflation, specifically via the recent decisions of both the Bank of England and the Federal Reserve to hike rates by a further 25bps. This week, there were relatively few top tier data prints, and thus for us, a chance to reflect on the underlying global macro backdrop in absolute terms.

We have long made the argument that we see inflation as far less resilient and the non-linear risks to demand (a factor highlighted last week by the Fed Chair) as much more acute than the market is pricing in relation to the forward-looking monetary response. Yet still we see analysts continuing to view the potential for further rate hikes as a function of relative tightness of financial conditions or relative fiscal impulse or even relative rate differentials (on a micro basis).

Indeed, we have long made the argument that the pace of monetary tightening (while distorted by pandemic savings) would likely have a significant and non-linear impact on consumption. Over the past couple of weeks, it has become clear that there was also another (important) part of the economy that was more sensitive to the speed of the US hiking cycle than the Fed or markets appreciated - the banking channel. It could be argued this too is a factor of absolute levels and not relative movements. As the Fed raised interest rates, the lending model (borrow short, lend long) became a problem. Banks (especially those where their interest rate hedging was insufficient - perhaps lulled into a false sense of security by forward guidance pledges and academic constructs such as FAIT), while raising deposit rates (relative), were not able to keep pace with the FFR. Thus, the absolute level of rates made money market fund yields very attractive. This problem was exacerbated further, as the Bank of England’s Governor highlighted, by the ease with which modern technology and communication makes transferring funds.

If the absolute level of interest rates on offer from money market funds was an important factor in defining the initial boundaries for the impact of monetary policy tightening (even if that monetary policy transmission has been delayed via pandemic funding as suggested above), so too, we would argue, are the absolute levels of prices.

When we think about policy transmission, we should think about the absolute tightening of financial conditions and its impact on aggregate demand. From our perspective, however, there has been too much emphasis on the tightness of the labour market and the effect of excess savings on demand (and we feel that the non-uniform distribution of these factors likely understate the forward implications for aggregate demand).

Essentially, this is the argument we have often made recently - that of the squeezed middle. Through the pandemic, there were huge fiscal transfers, predominantly to the low end of the income spectrum (though we have argued that such ‘excess savings’ have now been exhausted). Meanwhile, the vast majority of labour market tightness and real wage gains have also come at the low end of the income distribution. However, we would argue that the most important part of the workforce from a policy perspective is the middle. The middle have had declining real incomes, sharply higher nominal prices, sharply higher nominal cost of money or credit (not to mention the implications of recent tightening credit conditions) higher taxes, falling asset prices (most notably property) and a significantly less ‘tight’ labour market - all themes that we think are likely to persist in the near term.

While commentators continue to focus on relative shifts in financial conditions and relative shifts in the fiscal impulse, we continue to see the absolute levels of prices as a key near term risk to the absolute level of consumer demand and by extension inflation.

We have long debated the transition of market focus back towards growth and away from inflation, the core of our argument being that we struggled to see the persistent threat of inflation that the market feared. Indeed, as we have discussed above, we continue to see non-linear risks to growth, from the absolute level of prices, taxes and credit (particularly as falling asset prices - housing - undermine confidence). Ultimately, we suspect that this will equate to a negative demand shock, just as the global supply shock normalises (as huge amounts of global trade data now show), undermining, not propagating the persistent inflation narrative. We continue to see inflation falling sharply through the rest of the year - and do not rule out the prospect of negative inflation (at least declining goods prices).

This is not just a US dynamic either - clearly there are significant distortions to the demand/inflation dynamic from the pandemic, but across Europe there are also many distortions as a function of energy prices (and the disparate energy subsidy programmes across member states). However, here too we see inflation falling rapidly over coming months - as Spain, but not Germany, suggested this week. Indeed, on the demand front, a recent IMF working paper (European Housing Markets at a Turning Point) highlights many fragilities in the property sector going forward. Problems exacerbated by current continued policy tightening.

Finally, we cast our attention towards the FX markets and the USD. While we see the inflation decline as a global phenomena and while some may argue that this is a complicated extrapolation in FX terms as the monetary impulse eases at varied relative rates around the globe, we prefer to view the USD on an absolute basis - one of significant overvaluation. With US rates likely the furthest into restrictive territory and growth slowing (but still not likely a hard recessionary backdrop), we envisage the USD downtrend can be facilitated as it sits at the trough of the Dollar Smile. Right tail risks are worthy of note, as always with the dollar; but for now, we see it as a function of absolute, not relative considerations.