This week’s conundrum: Inflation is going up, but financial markets are shrugging their shoulders. While the US central bank announced on Wednesday it would stop aid buying and is expected to see at least one rate hike next year, the Standard & Poor’s 500 index reached a record high. This also applied to the European stock exchanges, including the AEX.
It was little different in the bond market, where government bonds and other credits are traded. Interest rates on US government bonds fell slightly, to less than 1.6 percent for the ten-year bond. This also applied to robust European government bonds, of which the German ten-year bond saw the effective interest rate fall to -0.22 percent. The Netherlands is there, with -0.1 percent, but just above.
Also read: Inflation continues to rise. What’s behind that?
At first glance, these are not price movements associated with rising inflation and the expected response from the authorities: a tightening of monetary policy, higher interest rates and therefore a less friendly stock market climate.
Although the Bank of England, the British central bank, postponed an interest rate hike for a while on Thursday and the European Central Bank has yet to make an explicit statement about its plans, it can be expected that the ultra-loose monetary policy during the pandemic is over. Perhaps even the already ultra-loose pre-pandemic policies. Because don’t forget: even then there were negative or zero interest rates and record amounts of support purchases of government bonds by central banks.
A parallel financial world has recently emerged in the cryptosphere – it can no longer be dismissed as an oddity
Why are the financial markets so insensitive? There are a number of answers to this – although a diagnosis remains difficult in an atypical recovery from an atypical recession.
More investors
First of all, there is the stock market itself. The longer the boom takes, the more new investors sign up. Profits on the housing market, for example, can be partly plowed back into equity investments. Companies lend a hand themselves: up to and including last month, shares worth 870 billion dollars (755 billion euros) were bought by listed companies. That is already more than the previous annual record from 2018. In Europe, that amount is probably only a quarter, but it is also very large in relative terms. And many corporate profits can keep pace with inflation if companies raise their own selling prices. That can also support stock prices.
In addition, a parallel financial world has emerged in the cryptosphere in recent years. And it can no longer be dismissed as an oddity. At the end of 2019, the combined value of all bitcoin was $139 billion. That is now the formidable amount of 1.159 billion. Ethereum, the number two cryptocurrency, has a market value of $533 billion. That is paper wealth, but it is possible that crypto owners cash in part of their profits and invest in the real world.
Also read: ECB sails risky inflation rate by not adjusting monetary policy
The wealth in the everyday economy is now great. ING’s James Knightley calculated this week that American wealth has risen by $22.6 trillion since the start of the pandemic — that’s $78,000 per average American. This will not be much different in Europe, with house prices and stock prices also rising. Although such wealth is very unevenly distributed, it may explain why investors who have a sizable buffer are not easily startled. And be prepared to buy every time there is a dip in the prices.
Another explanation for the relative calm in the financial markets is that the high inflation is temporary and will simply return to normal levels next year. That is still the working hypothesis of the central banks. And at first glance that makes sense. For example, if energy prices remain at their current high levels, they will no longer have risen in October 2022 compared to today. Their contribution to inflation has then become zero.
Price increases
In that case, inflation must be prevented from settling, for example leading to lasting large price increases through higher wages. The omens for this are becoming less favourable. Thursday showed that the eurozone had 4.1 percent inflation in the month of October. The US inflation figures for that month will be released next Wednesday. Analysts expect an average figure of 5.8 percent. Those of the Japanese investment bank Nomura even said 6 percent on Friday. Not unimportant: a ‘core inflation’, ie without energy and food, is expected of 4.4 percent. That’s high, and potentially persistent. In the eurozone, core inflation is much milder at 2.1 percent. But that is high for the eurozone, and the question is whether current monetary policy is still appropriate. Because 0 percent interest at an inflation rate of 2 percent means a ‘real interest rate’ of -2 percent. And that is still very stimulating for the economy.
The ‘pigeons’ – proponents of loose monetary policy – still determine the approach
A great unknown is still the labor market, where there are significantly more jobs on both sides of the Atlantic than people entering the labor market. That too can lead to extra shortages and wage increases for those who do report at the gate. On Friday, it emerged that US hourly wages rose 4.9 percent year-on-year in October.
One way for investors to protect against inflation is to buy government bonds that pay an interest on top of inflation. In the US, these are so-called ‘Treasury Inflation protected Securities’ (Tips), which have become increasingly popular this year. Last month, $6 billion in new investor money flowed in.
From the difference in interest rates between Tips and ordinary government bonds, it can be deduced which inflation investors expect on average over the term of those bonds. For ten years, that in the US is now an average inflation of 2.6 percent, according to Fred, the economic database of the US central bank. In the eurozone, a comparison between French inflation-protected government bonds (OATis) and ordinary government bonds results in an expected inflation rate of close to 2 percent over the next five years, data from ING shows.
Humble intentions
That is all significantly higher than before the pandemic, and so monetary policy risks falling behind considerably – even if it were tightened slightly. After all, with such inflation expectations among the public, central bankers are pretty much where they want to be – and should normalize their policies. Given the current state of monetary policy, and the modest intentions made so far to tighten it very slightly, Bank of America economists said on Friday that the “pigeons” (proponents of accommodative monetary policy) are slashing monetary policy. still reign.
In the meantime, they are doing well on the stock exchanges. In an interview with the site centralbanking.com this week, US economist Larry Summers drew a comparison with the past: not the oft-cited 1970s, but the 1960s, when inflation slowly but surely started to rise. “First, we deny that inflation is rising and predict that it will remain low. Then we attribute the inflation to a range of factors, which change every month. Then we take courage from the one or two months when, due to special circumstances, it falls. And then we argue that what’s so damaging about slightly higher inflation compared to the cost of a recession (which you can cause with higher interest rates), especially for the less fortunate.”
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Summers has some right to speak. Together with former chief economist of the IMF Olivier Blanchard, he predicted the current inflation peak this year. As for the stock markets, when inflation picked up in the late 1960s and the tide started to turn, there were a number of stocks that were seen as exceptionally sturdy and reliable, and continued to rise for a long time to come. Only when this group, the ‘Nifty Fifty’ started to fall, did a disappointing stock market climate set in, which would last for a decade.
Are central banks now waiting too long to take action to curb inflation? Summers cites William McChesney Martin, the central banker who said his job is to “take out the bowl of punch when the party gets going.” But perhaps the financial markets have already grown so large compared to the real economy that no one wants to afford a stock market crash anymore. Not even if the fight against inflation suffers as a result. And they really feel that on the exhibition floor.
A version of this article also appeared in NRC Handelsblad on 6 November 2021
A version of this article also appeared in NRC in the morning of November 6, 2021
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