Regime shift: central banks will prioritise inflation over growth

2022 was a landmark year for monetary policy. For some time, central banks had blamed rising headline inflation on a series of shocks: post-Covid supply chain issues, along with higher food and energy prices related to the Russia-Ukraine conflict. These factors were seen as transient, and so policymakers felt that tightening monetary policy would not have much impact. However, it became apparent that these temporary cost increases had triggered pressures elsewhere, and that they had spread to other parts of the economy. Suddenly, inflation in services sectors was rising sharply, with wage growth being a major contributor.

Central banks acknowledged that the external shocks could no longer be looked at in isolation. These shocks, they came to understand, should be viewed in the context of wider changes in the global economy which had occurred over a much longer period of time. Past circumstances which had helped contain wages, the cost of imported goods, and energy prices, say, could no longer be relied on in the future. Gradually, policymakers accepted that we are in a new regime of supply side shortages and more frequent price increases (see Regime shift: investing into the new era).

Certainly, the pandemic had a profound impact on labour markets, especially where governments had not stepped in to protect jobs. For example, in the US, the unemployment rate rose from 3.5% in February 2020 to 14.7% in just two months. As the economy re-opened, generous government aid and the movement in jobs made it very difficult for companies to hire people back and to respond to pent up demand. This helped return the unemployment rate to pre-pandemic levels by mid-2022, and drove wage growth up.

Total private sector average hourly earnings reached 5.3% in 2022, which remains the highest reading since the series began in 2008. The same series for the production only sectors has a longer history, and on this measure, earnings growth in 2021 reached 6.4% - the most elevated since 1981.

Central banks have probably already done enough to lower inflation in the near-term, but there has been a regime shift in the trade-off between growth and inflation.

Moving ahead, the global economy is likely to continue to face cyclical inflation and ongoing labour shortages, pushing labour costs higher. The global economy must also learn to cope with rising structural inflation associated with political fragmentation and the response to the new world order. Deglobalisation has put an end to the globalisation dividend and so there is less room for domestic inflation pressures as there was in the past.

Commendable as it may be, decarbonisation, and the transition to a more sustainable economy is likely to be a very inflationary trend.

Structurally higher inflation also means that monetary policy must remain tighter and more restrictive than before the pandemic if central banks are to meet their obligations to maintain price stability. The regime shift will result in higher interest rates for longer, and a reduction in global liquidity.

Nonetheless, higher interest rates will have significant consequences for investors and financial markets. From the implications for asset valuations, to the additional volatility that will be introduced. Investors will have to adapt to a world where the “Fed put” cannot be relied on to bail-out risk assets. The era of free money has come to an end.