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“Now I see, but I don’t know"

- Blondie, I Know But I Don’t Know

This week, I was reminded by a prominent Emerging Market fund manager that often when we refer to things as complex, it is because we do not fully understand them. At the heart of global uncertainty and indeed market sentiment at the moment remains inflation – its drivers, transience/persistence, near term policy implications, medium term growth implications and even its effect as a global differentiator.

Central banks are essentially set up to manage Aggregate Demand (AD), in that monetary policy accommodation or lower rates are aimed at increasing the incentive to consume or invest, thus increasing the ‘demand’ for goods. Higher rates, conversely, reduce the demand for goods and investment (at the margin), thus reducing price pressures.

The problem – and thus the uncertainty in the global economy at the current juncture – is that the root cause of price pressure is coming from Aggregate Supply (AS) and thus while there is increasing focus on the second round effects of inflation (through margin compression and wage demands), the ultimate driver of inflation has uncertain duration, magnitude and longer term implications through the impact on the anchoring of medium term inflation expectations. The current inflation backdrop is therefore complex.

A real world example of the complexity: Earlier this week I listened to a BBC Radio 4 interview with a poultry farmer/distribution company who tried to explain their current multitude of cost pressures (from manual labour shortages to carbon dioxide prices, plastics prices, higher distributional costs and higher energy input costs) for an end product, a chicken, that is 30% cheaper than it was 10 years ago. Whether this is a function (or combination of) globalisation, labour and competition, is an interesting debate, but it is not entirely clear how this is resolved at the consumer price level and whether the adjustment is a one-off (transitory) price rise or a more prolonged, persistent upward move?

For us, this is an important example of the complications of the current inflation dynamic. Supply chain issues in and of themselves are likely to be a transitory (or episodic) factor. However, the trend away from pre-crisis globalisation and changes to the labour market dynamic add ‘complexity’ to global inflation, its underlying drivers and its persistence.

This week, we got the release of the Minutes from the September Federal Open Market committee meeting. On the surface, the Minutes are entirely consistent with the communication from the meeting and press conference in September; the announcement of tapering of the Federal Reserve’s (Fed) asset purchase programme is expected to come at the November meeting, with the programme to begin mid-November, or mid-December, and conclude around the middle of 2022. However, there was also clearly a greater emphasis or concern about inflation apparent in the Minutes: many of the participants saw inflation risks to the upside… some saw inflation remaining elevated into 2022… some even raised the prospect of raising the target range by the end of next year and adopting a faster pace of tapering.

In many respects, the key point here is the uncertainty. The Fed committee members are increasingly keen to end asset purchases (some faster than others) so as to give the Fed the optionality to raise rates sooner, should inflation prove more persistent, or more pernicious than expected. Furthermore, this has significant implications on a global basis in terms of differentiation. Not all central banks, indeed I struggle to find a good example, have the ‘optionality’ on monetary policy that the Fed likely enjoys (for the next 6 months or so).

EM central banks have been at pains to get ahead of inflation and the de-anchoring of inflation expectations as inflation struck this year, aiming to maintain financial stability and a yield buffer ahead of a US normalisation process that has a troublesome precedent in the fallout from the 2013 Taper Tantrum. But, it is not clear what the implications for medium term growth are, as a result of this steep tightening.

Indeed, in Developed Markets (DM), as we discussed last week, the UK is likely in the eye of this specific storm at the moment, facing acute supply chain, labour market, commodity and deferred demand-driven price pressures. Markets are now pricing a rate hike path in response to inflation that will take the Bank of England base rate to 1.0% by the end of 2022 – above the pre-pandemic rate level and the tightest monetary policy setting since the global financial crisis.

The Federal Reserve Bank of Cleveland President has stated that she was more comfortable with current wage gains due to rising productivity levels. If wage gains can outpace inflation over the cycle, then the normalisation cycle can continue along with higher growth. This is a trade-off that may be less common outside of the US. Differentiation – a theme we have held for many quarters now – remains likely.

We continue to believe that the US will continue to widen its equilibrium growth rate relative to the rest of DM, and as many other central banks face more acute trade-offs between price pressures and the implications of higher rates on medium term growth prospects, this differentiation likely becomes more apparent.

In short, some countries face more complexity than others. Against this backdrop, we expect FX volatility to rise and a more macro-driven price action in risk assets to emerge.

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