Central banks change their tune on inflation

“The expectation going into this year was that we would see inflation peaking in the first quarter and maybe levelling out” before cooling in the second half of the year, US Federal Reserve chair Jerome Powell said this week. “That story has already fallen apart.” With annual inflation running at 7.9% in the US and 6.2% in the UK and global commodity prices surging because of Russia’s invasion of Ukraine, central banks around the world are being forced into inflation-fighting mode.

Last week the Fed raised interest rates for the first time in four years, while the Bank of England delivered a further 0.25 percentage point hike to 0.75%. This week Powell suggested that the Fed could even serve up a half-point increase (rather than the usual quarter-point increment) at a future meeting if it felt inflation was running out of control.

Don’t mention the war

The key message from central bankers in Europe and America is that the war in Ukraine will not derail their plans to tighten monetary policy, says Neil Shearing of Capital Economics. The risk is that this cycle of interest-rate rises will end up causing a recession. The “lessons from history are troubling”. Of the 16 tightening cycles done by the Fed, Bank of England and European Central Bank since the late-1970s, 13 ultimately ended in recession.

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The Bank of England now projects that UK inflation could hit 8% in the coming months, four times the 2% target, says Mehreen Khan in The Times. Even “double-digit inflation” looks a possibility later this year, for the first time since the early 1980s. But critics think the Bank is “dangerously behind the curve on taming inflation”, with the Bank’s reference to “further modest tightening” taken as an indication that it intends to hike less quickly than the Fed from now on. “The Ukraine crisis has changed the mood.” Markets are now expecting UK rates to be around 2% come the end of the year, down from a forecast of 2.5% previously.

Stocks are on thin ice

Tighter monetary policy has caused bonds to sell off as markets demand higher yields. US two-year Treasury notes are on course for their worst quarterly performance since 1984. Yet surprisingly stocks have so far avoided the pain, with US markets enjoying their best week since November 2020 last week and continuing to rally this week. In Europe, the Stoxx 600 index has erased its post-invasion losses. In another sign that markets have digested the invasion shock, the Vix index of expected volatility derived from S&P 500 option prices – dubbed Wall Street’s “fear gauge” – has fallen back to early February levels.

Higher interest rates should be “terrible for stocks and even worse for unprofitable tech shares”, says James Mackintosh in The Wall Street Journal. So why is even Cathie Wood’s ARK Innovation ETF of highly speculative stocks enjoying a bounce? Some traders are going bargain-hunting: over the last 30 years, they have got used to buying dips on the expectation that the Fed will “ride to the rescue” if stocks tank. But with central banks now focused on fighting the inflationary peril, buyers shouldn’t count on a “Fed backstop” this time.