Forget overkill. Central banks are still way behind

Expectations of how much central banks will push interest rates higher to get inflation under control have increased to such an extent that some are starting to talk about overkill. Markets now think that benchmark rates in the US will top out at about 4.7% (from 3.25% now), 3% in the euro zone (from 1.25%), and 5.8% in the UK (from 2.25%). Partly as a result -- though also because energy prices have fallen -- expectations for inflation over the next five years has tumbled.

That combination is why expected real rates — yields on conventional bonds minus the expected inflation — have spiked higher. Perhaps unsurprisingly, the UK has led the pack, and over the past year expected five-year real yields have risen an extraordinary five percentage points. But the surge in expected US real yields has not been far behind. This vertiginous rise has clobbered financial assets and led to all the muttering about overkill. The extraordinary thing about rates, though, is not how high they are but how low. They will have to increase much more to get inflation sustainably lower.

A big reason for the expected drop in inflation is that investors big and small were used to a world in which disinflation seemed more of a problem and think it won't take much to bring it back. The same is true of central banks and, strange as it may seem, they still have a lot of credibility.

Broadly speaking, these views are supported by three main arguments. The first is that you can't get much inflation given the unprecedented amounts of debt outstanding in the world today. What people generally mean by this is the expense of servicing all that debt at higher interest rates would rapidly eat into demand and thus growth. However you cast the argument, it is wrong. Simply put, if nominal growth is much higher than nominal rates, debtors are in heaven and creditors in hell. There are exceptions, such as highly leveraged companies, governments that link lots of pensions to inflation, or households in the UK borrowing at floating rates. But unexpectedly strong inflation mainly clobbers creditors. Look for evidence at the appalling real returns on bonds over the past couple of years.

A $300 Trillion Debt Pile
The amount of debt outstanding globally has reached unprecedented levels totaling 350% of GDP

Source: IIF, BIS, IMF, Haver, National Sources

The second argument is that the amount of money sloshing around in developed economies is rapidly slowing, thereby choking the life out of both growth and inflation. The problem with this argument is twofold. The first is that it confuses stocks and flows. While money growth is indeed slowing, the stock of money remains very high. The second is that monetarists aren't good at accounting for the velocity of that money, or how fast it circulates around the economy. Having fallen like a rock for many years, velocity is picking up, supporting inflation pretty much by definition.

Rapid Slowdown
Growth in the US money supply has decelerated to pre-Covid rates

The third argument is that slower economic growth will bring inflation rates down. Certainly, most of the developed world has been slowing and China has fallen into a very deep hole, cutting global demand. The Bloomberg Commodity Index is down more than 15% since June and West Texas Intermediate oil prices by about 25%. Together with energy price caps in many countries, this is likely to reduce headline consumer inflation.

But I have severe doubts the slowdown in growth will be enough to bring inflation down to the sort of levels markets expect, let alone tackle how much it has spread from the initial supply shocks. In any case, one should view prognostications on inflation from central banks and markets with healthy skepticism. Both have consistently and dramatically underestimated the inflationary surge of the past two years. Even now, all that has really changed is that they have put off when the drop in inflation rates will happen, the level from which it declines and the interest rates required to reduce it.

Perhaps the reason for getting it so wrong over the past couple of years is because they have the wrong diagnosis both of what happened in the 1970s and what has been happening these past few years. The 1970s inflation started long before the first oil shock and continued long after its effects petered out. Inflation became such an intractable problem because over the years it broadened into every nook and cranny of the global economy. There are many similarities this time round, though with a twist. Headline inflation was driven lower for many years by falling prices for traded goods. Central banks reacted by keeping their foot firmly on the monetary stimulus pedal, even though interest rates had almost no effect on the prices of tradable goods and despite there being no signs that falling prices for traded goods was leading to lower domestic inflation, such as in services. It probably meant the opposite. Wage inflation, after all, has been rising for years. Over the past couple of years overall inflation has both broadened and climbed. Take the Consumer Price Index in the US. The median reading has increased from less than 2% in January 2021 to 5.8% currently. Leading the median upwards of late has been much higher prices for services rather than goods.

If the world ended up with interest rates that were far too low for too long, recent and expected moves would only just undo some of that. Although markets expect real rates to be very positive down the road, this mostly depends on their being right that inflation will fall very sharply. For now, the gap between short-term term rates and inflation has never been wider. This is why one would struggle to find any model which churned out a required rate to slow inflation at anything like their current levels. Take, for example, the well-known Taylor rule. You can just about get a rate of 5% in the US if you skew the inputs sufficiently. On more reasonable assumptions, rates would need to be something like 10%. For the UK and euro zone, they would need to higher still on any assumptions.

The dead hand of bad past monetary-policy decisions is also evident in the surprising lack of movement in yields on longer-dated bonds, UK government debt apart. A big reason they haven't moved higher is that, thanks to huge quantitative easing and foreign-exchange intervention in the past two decades, central banks now hold a huge amount of outstanding government debt. Much higher long-term yields would have helped cool inflationary pressures. Absent such a move higher in long rates, central banks will have to do more heavy lifting with short rates.

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Major central banks have seen their assets balloon to more than 50% of their GDPs from less than 10% before the financial crisis

All this would only need to be halfway right for current rates to be wholly wrong. I simply cannot imagine Karl Otto Poehl, the president of Germany's mighty Bundesbank from 1980, being anything other than derisive about what is currently being priced into markets. As Germany showed from the 1970s on, the monetary response to inflation matters. Expect more than muttering in coming months.    

Richard Cookson was head of research and fund manager at Rubicon Fund Management. Previously, he was chief investment officer at Citi Private Bank and head of asset-allocation research at HSBC.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.