It's hard to remember back more than 14 years to a time before governments and central banks so heavily influenced economic outcomes. After 2008, markets reduced their emphasis on economic fundamentals. Monetary and fiscal conditions gained greater significance in investment decisions.
That heightened significance came with a bias. Investors knew governments and central banks sought to promote their economies. They did not want serious economic meltdowns to occur.
Monetary and fiscal interventions became synonymous with reduced market risk. Low interest rates stimulated asset prices. They also stimulated borrowing to worrying levels. They reduced net present value discount rates and justified markets being bid up. The New Zealand housing market was one example of market mispricing. World share markets were another.
Then worldwide inflation appeared to spoil the party.
How do people react when they see things happening which contradict a strong view developed over 14 years? Answer: initially they don't believe what they are seeing.
Inflation stopping governments spending and central banks pumping money? It can't be happening.
The US Federal Reserve (the Fed) was a prominent example of denial behaviour. Initially, the Fed said it was intentionally letting the US economy run hot, with inflation modestly elevated. United States inflation then increased to 4.2 per cent in April 2022. It must be transitory. It will disappear when supply chains free up. But US inflation by June 2022 at 9.1 per cent? Shock, horror. Denial is no longer possible. This is serious. The Fed started tightening urgently that month.
Other central banks such as the European Central Bank and the Bank of England appear still to be in denial. Both are still to raise rates close to levels needed to control their inflation.
But what about markets? After 14 years of mollycoddling, they faced an even bigger mental shock accepting monetary and fiscal interventions were now off the table.
Extremely accommodating monetary policy around the world, changing into restrictive monetary policy? It can't be happening.
Until September 2022, markets also appeared in denial. Yes, stocks fell and bond rates rose during the first half of 2022. But then much of these declines reversed in August.
United States inflation peaked at 9.1 per cent in June and then dropped back to 8.5 per cent in July. Surely the worst must be over. Interest rates should start coming down. The benign conditions of the last 14 years will return.
This wishful thinking in markets finally ended in September. What changed investor outlooks? First, a strong speech by Federal Reserve chair Jerome Powell at the meeting of the world's central bankers at Jackson Hole, Wyoming, stating there was much more tightening to come.
Then an unexpectedly high 8.3 per cent US inflation figure for August, quickly followed on September 21 by the third successive 75-point Fed hike to 3-3.25 per cent. At the same time, the Fed raised its predicted maximum funds rate to around 4.5 per cent, suggesting plenty of tightening still to come.
Adding to the Fed's strong message: in the same week beginning September 19, other central banks around the world raised rates in total by 700 basis points. Central banks everywhere now view inflation seriously.
Market realisation that 14 years of easy money has ended, has consequences. September 19-23 saw stock market declines. Investors moved to protect themselves.
In the four weeks to September 23, the US saw US$34 billion outlaid buying put options to limit potential market downside. This was the largest total of put options on record, and four times the average since the start of 2020. It roughly equates to the level of put options during the GFC.
Then to hammer home to investors there was no going back, the UK (with inflation at 9.9 per cent) on September 23 delivered a mini-budget of tax cuts and big deficits. The pound dropped immediately and UK interest rates jumped. The UK rashly proved that countries with significant inflation can no longer spend their way out of trouble.
September 2022 was the month markets appeared to accept the world had moved into a new economic environment. Inflation must be defeated with higher interest rates.
Economies will experience slowdowns as a result.
Economic policy everywhere has done a U-turn. Worldwide inflation is necessitating the reversal of 14 years of easy money and fiscal deficits. It is a long journey back. Has the world yet realised how far?
Many central banks expect nominal interest rates in their countries to peak at 4-5 per cent. But that may be too low. A country's REAL interest rate is its nominal interest rate, less its inflation rate. When nominal rates are below inflation, a country has negative real interest rates.
To be confident of beating inflation, countries will likely need positive real interest rates. Most are currently well short of that level. New Zealand, for example, needs to raise rates by a further 4.3 per cent to reach positive real rates.
Inflation may reduce of its own accord, if oil prices fall, say, or the Ukraine war ends.
Then the further rate increases needed for countries to reach positive real interest rates will be smaller. Exact quantification is not possible, but calculations suggest interest rates in most countries may need to rise further than currently anticipated, to bring inflation in their economies under control.
In New Zealand, the central bank rate may have risen to 3 per cent, but inflation at 7.3 per cent means the real rate is still negative 4.3 per cent. A similar pattern of negative real rates is true of many other countries.
Reversing 14 years of expansionary fiscal and monetary policies since the GFC will not be easy.
- David Schnauer is an economist, retired lawyer and the author of Covid, Catalyst for Change.
