Do investors know something we don’t? News that both headline and core US consumer inflation had come in higher than expected – against a backdrop of the World Bank and IMF slashing their growth expectations – saw the US stock market indices soar 2.5%-plus and European indices rise more than 1% on the day.

Intraday, the Dow Jones Industrial Average first plummeted 500 points on the CPI data release, which recorded core inflation, considered a good reflection of broad-based price pressures, experiencing its biggest annual increase since August 1982. The index then went on to recover 800 points.

The market moves certainly defied reality during a week in which there was little to celebrate. In addition to the disappointing inflation data, the Fed minutes reiterated its take-no-prisoners monetary policy stance, stating that the “cost of doing too little outweighed the cost of doing too much”. 

The World Bank then reduced its growth forecast to 1.9% in 2023, saying we are “dangerously close” to a world recession.

The Fed’s unbudgeable stance in the face of ongoing hopes that it will soften its approach is a far cry from its hands-off approach last year when it viewed inflation as transitory and largely due to unprecedented Covid-specific economic forces.

Though expectations of the central bank pivoting have subsided, there are some economists who highlight that the headline inflation numbers don’t tell the whole story. They say there is sufficiently significant evidence of deflationary forces emerging in the underlying components of the index to suggest that “Team Transitory” is still in the running. 

UBS chief economist Paul Donovan is one of them. He says last year’s US inflation drivers have turned into deflation, meaning that Team Transitory was right. 

He points out that durable goods prices declined 1.1% month on month in September – the largest fall ever – and homeowners’ costs of living remain much lower than consumer inflation. He points out that the prices of more than 40% of the core goods basket, and 35% of the food basket, came off in September and, as a result, “consumers are seeing deflation as well as inflation, possibly increasing their willingness to consume”.

Oxford Economics Global Macro Strategy Director, Javier Corominas, addresses the implications of relying on backward-looking inflation data: “The Fed’s single-minded focus on actual versus expected inflation outcomes, could have backed them into a corner, as they wait for a few months of lower inflation prints to validate any pivot. Given the lags with which monetary policy operates, this could prove costly.”

He notes that central banks have come to rely less on their internal inflation models, instead responding to actual, current inflation data, which doesn’t consider the lagged effects of past rate rises that will impact in 2023.

The bottom line for Corominas: financial stability has also become a key risk for policy makers, given the lack of liquidity in government bond markets and rattled investors.

In their Blackrock Investment Institute’s fourth-quarter 2022 update, the global investment manager warns that a deep recession will be needed to get inflation back to the Fed’s inflation target of around 2%. 

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It says: “Getting inflation back to central bank targets means crushing demand with a recession. Policymakers are recognising a new macro regime but are ignoring the true trade-off between inflation and activity.” 

The investment manager says the central banks’ focus on bringing inflation implies the following: overtightening monetary policy, inflicting significant economic damage and signs of inflation easing only appearing “many months” later. 

Thus Blackrock expects central banks to come to the point where they will live with inflation. 

“We think central banks will eventually confront the trade-off in its entirety. Once they see the cost to growth and jobs materialising, they’ll likely choose to take longer to bring inflation to target and give the economy a chance to rebalance as production capacity slowly recovers.” 

In this event, inflation will stay higher for longer – a better outcome as long as inflation expectations remain anchored.

A core takeout of the IMF meetings during the week was that policymakers need to adopt a steady hand because the risks of getting it wrong have escalated “amid high uncertainty and growing fragilities”. 

Nowhere is this more apparent than in the UK, where Prime Minister Liz Truss’ financially calamitous fiscal proposal has resulted in the firing of newly appointed Finance Minister Kwasi Kwarteng. 

Recognising the risks of central banks either over- or undertightening, IMF chief economist Pierre-Olivier Gourinchas accentuates the consequences of the latter, namely de-anchoring inflation expectations, and maintains the importance of remaining laser-focused on bringing inflation down.

He acknowledges that markets may struggle with overtightening, but argues: “The hard-won credibility of central banks could be undermined if they misjudge yet again the stubborn persistence of inflation. This would prove much more detrimental to future macroeconomic stability.”

It’s coming up to a year since Fed chair Jerome Powell retired the word ‘transitory’ from the Fed’s vocabulary. Whether the central bank is able to maintain a steady hand and achieve its desired results without sinking the world economy and financial markets remains to be seen – but you don’t have to look far to see the risks of a painful fallout are high and growing. BM/DM