Central banks are walking a tightrope. If they provide too much monetary support for too long, the economy risks becoming unbalanced. At the same time, tightening policy too quickly has the potential to upset asset markets and cause a tightening in financial conditions that derails the recovery.  

This is always true for monetary policy, but this balancing act has rarely looked so challenging for two key reasons.  

The first is that financial markets have become conditioned to expect supportive monetary policy and are priced on that assumption. One only has to look across the government bond markets, and how even with inflation over 5% in the US and over 3% and rising in the UK and Europe, the bond markets are projecting easy money for years, with the US 10-year Treasury bond yielding just 1.6%. All other asset markets are priced off of risk-free rates, and so this is influencing valuations across the market spectrum. If central banks have to materially shift gears to head off inflation, a key assumption underpinning some of those lofty valuations would be challenged, potentially causing risk markets to stumble. 

The second reason is that the relationship between growth and inflation may have changed following the pandemic. In the economic cycle following the Global Financial Crisis, central banks struggled to lift inflation. Unemployment got very low yet wage growth and inflationary pressures remained muted. It was a time they could have their cake and eat it. Being too lax for too long didn’t appear to give rise to meaningful upside inflation risks.  

Today however, despite unemployment being above the level seen before the crisis, workers appear to have more bargaining power and wage growth has moved up notably.  

The inflation question

This makes it difficult to assess how persistent inflation will be. If many of the price pressures begin to abate as global production picks up and supply bottlenecks fade, then central banks will be spared from making difficult and potentially unpopular decisions. It’s a question that the economic forecasting community seems deeply divided on. There is a range of three percentage points for where they see US headline inflation in the second quarter of 2022 – central banks can’t see much of what’s ahead of them. 

Labour market shortages are more important to the central banks than product shortages. There are a large number of supply chain disruptions. The problems are broad and have been increasing in number; raw materials, semiconductors, shipping containers, logistics, energy prices to name a few at the top of the list. It is hard to say exactly how long some of these issues may last and so we think that central bankers will look to the labour market data, and in particular wages, to discern how sustained price pressures may prove to be. 

Businesses are reporting significant difficulty in finding workers and that’s showing in the numbers – job vacancies are at, or near, record levels in the UK and US. And as mentioned, companies are having to increase wages in order to retain and attract staff.  

It’s this combination of apparently tight labour markets with recent “cost-push” price shocks such as in energy markets that may make central bankers nervous. If workers are experiencing greater bargaining power when it comes to pay, then higher inflation could help establish an undesirable feedback loop that sustains price increases. 

We have already seen central banks begin to acknowledge that inflation will not to be as transitory as initially expected. The Bank of England has been leading the charge, announcing that a rate hike before the end of the year is a live possibility. Other central banks may soon follow suit in tilting policy in a more hawkish direction.  

Where do we go from here

Ultimately though, we think central banks will prefer to ease off the accelerator rather than slam on the breaks. Since being too abrupt risks a correction in asset prices and a recession, being behind the curve allows themselves more time for inflationary bottlenecks to perhaps ease and looks a more palatable choice. 

This leads us to think that government bond yields should continue to move gradually higher over the medium term. In turn, we expect that value and cyclical sectors of the market should continue to outperform their growth and defensive counterparts. Indeed if a high inflation environment were to persist, then this is historically an area of the equity market that has been able to weather that well. 

But given the risks around the central bank’s delicate balancing act, it makes sense to continue to employ strategies that can also add ballast to portfolios. We think that real assets, such as core infrastructure and real estate, can provide inflation hedging protection, while macro hedge funds have the ability to move dynamically across asset classes in volatile markets. 

With central banks set to perform a difficult tightrope walk, investors would be wise to ensure their portfolios are resilient to some bumps along the way. 

Ambrose Crofton is global market strategist at JP Morgan Asset Management.

Originally posted on Money Marketing.