Demand Destruction ≠ Disinflation
World central banks have made a “all-in” effort to accelerate policy tightening to curb demand. But weaker economic data in the UNITED STATES and the eurozone exacerbated fears of recession. As growth prospects darken, many anticipate demand destruction lead to lower inflation. In other words, tighter monetary policy and the higher financing costs associated with it will reduce demand and offset supply shortages resulting from geopolitical instability and supply chain disruptions. This view is based on the belief that inflation outcomes are largely determined by central bank policies.
However, “muted” inflation in recent years, especially during the crude crash of 2014 to 2016, demonstrated the insensitivity of inflation to demand-side policies. Even the European Central Bank’s (ECB) quantitative easing (QE) in 2015 failed to stimulate demand in a way that reduced excess supply. The US Federal Reserve’s accommodative policy in the decade before the pandemic pushed Atlanta Fed Wu-Xia Shadow Federal Funds Rate many times below zero, but the Fed’s favorite price measure, personal consumption expenditure (PCE), has been less sensitive to such policy shifts than it was at the end of the Cold War or entering of China in the WTO, among other catalysts.
Personal Consumption Expenditure vs. Shadow Federal Funds Rate
Similarly, the recent quantitative easing and rate hikes have not created enough demand destruction to counter the geopolitical commodity scarcity. Instead of following central bank policy over the past two decades, inflation has largely co-evolved with commodity prices, or with demand and supply factors.
Eurozone, US and UK inflation vs. commodity index
This casts doubt on the “rate-determines-activities-determines-inflation” framework and suggests that national monetary policy alone cannot raise or curb inflation. Other factors must come into play.
1. Tax expenditures = higher demand
Given EQs long and variable trickle-down effect, pandemic-era policies have sought to counter the demand shortfall by expanding balance sheets and through fiscal stimulus, or by printing money and sending checks directly to households. This drastically reduces the transmission time between central bank easing and realized inflation. The deployment ofhelicopter moneyquickly revived the request.
As the pandemic-related disruptions eased, the planned fiscal tightening never materialized. Instead, fiscal-monetary cooperation has become the norm and Cash payment a regular political tool. Following his Eat Out to Help Programfor example, the British government announced a £15bn package to send £1,200 to millions of homes. As UK energy prices soared, Liz Truss, the favorite to become the next Prime Minister, proposed an emergency budget spending package to ease the financial stress of the public.
On the other side of the Atlantic, many American states have announced stimulus payments to ease the pain of high inflationand President Joseph Biden has introduced a student loan relief program. The lesson is clear: central banks are no longer the only game in town when it comes to economic recovery.
2. Geopolitical events = supply disruptions
As multinationals regionalize, nearshore and relocate supply chains and prioritizing resilience and redundancy over cost optimization, energy scarcity in the Eurozone has created further disruptions. German chemical production is expected to fall in 2022, this could overseas export inflation.
As geopolitical instability contributes to domestic economic challenges and more fiscal stimulus is rolled out, inflation could be much less responsive to traditional monetary drivers. In such circumstances, a rigid framework that equates tight monetary policy and high prices with demand destruction and disinflation will no longer apply.
For investors assessing portfolio risk, such conditions can offset disinflationary pressures from slowing growth.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Pavel Muravev
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