Investors are still in denial about inflation and interest rates

“Central bankers are in an unenviable position,” says Ben Wright in The Daily Telegraph. “They must choose between death by a thousand price rises or the electroshock therapy of massive interest-rate hikes.” There are worrying signs that inflation is becoming embedded in the economy. UK service-sector inflation hit 5.9% in August, threatening a “wage-price spiral”. Even if headline inflation does peak soon, it could then stay “well above central bank targets for much longer than previously hoped”.

With energy prices falling, concern on both sides of the Atlantic has shifted towards core inflation, the measure that excludes volatile food and energy prices, says Hermione Taylor in the Investors’ Chronicle. The UK’s costly “new energy-price scheme means that the inflation outlook has materially improved”, banishing talk of 20%+ consumer price inflation.

But annual core inflation crept up to 6.3% in August. The prospect of “stubbornly high” underlying inflation shows that “we are not out of the woods yet”. Repeated inflation shocks have kept central bankers in tightening mode. This week’s full percentage-point jump in Sweden was the biggest hike since the 1990s.

Many investors are still holding out hope for a Fed “pivot… the mythical moment when it decides to dial down the interest-rate rises that have been pummelling asset prices this year”, says Katie Martin in the Financial Times. The result is traders have had “a fainting fit every time this year that US inflation data has turned out to be surprisingly strong”.

You would think they would have got the message by now, but it seems some are struggling to adjust to the new reality. “It’s the… triumph of hope over experience,” says Trevor Greetham of Royal London Asset Management. “It’s a massive regime change. People still want inflation to be transitory and temporary.”

A Goldilocks scenario?

Asset manager surveys show that market opinion is currently evenly split between bulls and bears, says John Authers on Bloomberg. The bulls are betting that the threat of recession will prompt the Fed to pivot towards easier money “in the next few months”. Yet “inflation is too well entrenched for the Fed to be able to ease much, if at all, by the end of next year”. Count me a “bear”.

The problem with the bull case is that the only thing that will make the Fed change course is a nasty recession in the US, says James Mackintosh in The Wall Street Journal.

“But markets aren’t seriously preparing for a recession, with bets instead assuming inflation comes down sharply without killing the economy” or seriously damaging corporate earnings. Asset prices “have further to fall because investors are still clinging to the vestiges of the belief that inflation will soon be conquered”.