Further rate rises could lead to unexpected outcomes
In the second half of last year, economists en masse moved from only a relative moderation in monetary support needed to a now an accelerated raising of interest rates required. In fact, only this week, one of our major banks increased their OCR (official cash rate) target to 3.00% (previously 2.50%), despite noting ‘The housing market appears to be coming to a very sudden stop; households are facing significant cost-of-living stresses and have subdued confidence; a shortage of workers and materials is hampering production; and Omicron is knocking on our door’.
The reason for this change has been the significant inflationary overshoots in 2021 and some trepidation ahead of the release of 4Q21 CPI numbers. This is now not limited to New Zealand, with a more hawkish stance adopted by global central banks, especially the Federal Reserve in the US. Everyone is now jumping on the bandwagon, with at least 3-to-4 interest rate rises already baked in, as is an early start for tightening. So, what would be unexpected?
There are several outcomes to watch. I have maintained that annualized inflation of 5-6% is not sustainable and that investors are now close to the top of the inflationary cycle and that I expect headline CPI to drop significantly by the end of 2022. However, the next several months could still be trying, and even if headline CPI stays relatively flat, core readings might continue climbing through January and February 2022. If supply/logistics and labour market disruptions and bottlenecks do not start clearing through 1H22, central banks might increasingly feel trapped, and lean ever harder against the wind, potentially causing significant market corrections. This in turn would almost certainly see investors and households endure much higher-than-expected stresses.
However, equally likely is the outcome that leads to a much quicker erosion of both growth and inflation. As policy makers withdraw fiscal and monetary supports, supply chains and labour markets normalize, and China avoids sending a strong global reflationary pulse, inflation could start coming off far more rapidly than economists expect, returning to a more disinflationary climate towards the end of 2022 and early 2023.
Such is the uncertainty of Omicron, there is a possibility of wild swings between too strong and too weak demand, and between shortages and surpluses, causing a great deal of policy confusion. Added to this, investors are assuming that politics will look after geopolitics without causing any dislocation. Whether it is Russia vs Ukraine and how the West responds, or tensions in the South China Sea, investors are factoring nothing, even though the impact could be significant, particularly for commodities.
Whilst I remain constructive on markets, I fail to see how we can expect such a rapid unwinding of monetary support as we are supposed to believe that the Reserve Bank will raise interest rates at every opportunity in 2022. China has been consistently out of sync and ahead of the curve over the last 12 months, and it is already lowering interest rates.