The unprecedented combination of a pandemic and a large-scale land war in Europe shocked aggregate supply and demand. Assessing the balance between and persistence of them proved difficult, and we believe central banks mostly got it wrong in real time. For that reason, inflation is a worldwide problem, and in our view, the monetary-policy recourse to reclaim price stability will push many advanced economies into recession within one year. Moreover, we believe the return to low inflation will take longer than officials admit, which poses an outsized risk that they will reverse policy restraint before the job is done given divisions in the policy committee and outside pressure. Here, we tour the globe to digest regional implications of our inflation outlook.

United States

The Federal Reserve (Fed) appeared to be more concerned about supporting demand because it believed that supply disruptions would prove fleeting as the lifting of health concerns allowed the return to work and disruptions to transportation chains were worked around. In the event, demand was supported by massive fiscal stimulus more than fully accommodated by monetary policy, supply-chain disruptions persisted, health hesitancy lingered as the virus mutated, and a significant volume of important commodities did not show up on the world market. The withdrawal of fiscal stimulus and some monetary accommodation this year has slowed the growth rate of aggregate demand, but not to that of aggregate supply. The recently enacted fiscal legislation will barely move the needle on inflation and the federal deficit, and not in the advertised direction at first. Aggregate economic data are noisy, and one important metric, real GDP, has contracted over the past two quarters, but this seems more related to an inventory and trade cycle rather than about underlying momentum. More telling, employment growth, with payrolls increasing almost ½ million per month recently to bring its level to the pre-pandemic norm, retains vigor. The expansion of aggregate demand must slow more to contain inflation, and in the interim its level will continue to exceed efficient supply, as it does now and attested by an unemployment rate that is well below most assessments of its natural rate.

We fear inflation has plateaued, not peaked, and that correcting the problem involves a hard, long slog. Inflation in the US is at a forty-year high and nowhere near the neighborhood of what Volcker and Greenspan called price stability. The latter is of import because, outside that comfort zone, households and firms fret incessantly about changeable prices, which is why the topic has risen to top of mind among the public. Feeding into cost pressures are the catch-up in business costs as people attempt to recoup lost purchasing power, the need for firms to pay-up for scarce workers, and the creep-up of the public’s inflation expectations, which feeds into cost and price pressures. Swinging from a major impediment to a major benefit—sometime soon but not as soon or as much as Fed officials hope—is an improvement in aggregate supply as global supply chains mend and health hesitancy lifts. Russian adventurism on the ground in Eastern Europe and in energy and other commodity markets, as well as the hardening of the wall of global sanctions and opprobrium among the nations that have chosen sides in the Ukrainian conflict, will slow the former process in our view. As for the latter, the ability of the coronavirus to mutate beyond the protections of immunization and natural immunity makes it likely that concerns about personal health and lockdowns in the world’s second-largest economy linger.

We think Fed officials must do something hard, raise the policy rate to tighten financial conditions to slow the growth of aggregate demand to bring it into better alignment with the level of aggregate supply. Only then can inflation be brought down. We think they will tighten more than currently priced into markets but fear their resolve to return inflation to goal within the next two years will flag as concerns about economic recession mount inside and outside the policymaking committee.

China

China is testing its economic-growth model both externally and domestically. Externally, by supporting Russia in its territorial aggression, Chinese officials chose to put the nation on the other side of a wall of sanctions and opprobrium erected by advanced economies. Moreover, the recent expression of the scope of China’s regional ambitions has increased global concerns. Domestically, China was apparently first in and last out in dealing with the pandemic. Given its zero-tolerance policy toward the coronavirus, the population has little natural immunity and relies on an apparently inefficacious vaccine. Lockdowns are disrupting manufacturing activity once again and deflating household and business confidence. Property price losses and payment difficulties are lessening the contribution of that sector to economic expansion. These domestic strains are keeping inflation in check despite the rise in commodity prices. The Peoples Bank of China’s move to increase accommodation is limited somewhat by concerns about reigniting financial excesses.

Euro Area

The Euro area has had an uneven pandemic, is closer to the conflict, and relies more on the combatants for commodities. As a result, inflation wildly outstrips the European Central Bank’s (ECB’s) price-stability mandate, and recession within the year appears almost inevitable. Monetary policy has been accommodative for a considerable time, during which the macro interest of the North in stimulating demand aligned with the micro interest of the South in suppressing rate spreads. Not so going forward as the ECB has pulled its policy rate out of negative territory, and more firming is in store. However, the aggregate withdrawal of accommodation will be offset somewhat by intervention to keep sovereign spreads within the zone well behaved. Domestic pressure on inflation is likely to pick up given the erosion of purchasing power, even as economic recession is likely. We believe both will strain national and private balance sheets.

United Kingdom

We believe economic activity in the United Kingdom is at most risk among the Group of Seven nations, as recently admitted by the Bank of England (BOE). More immediately, inflation is running around 9 percent, well north of any notion of price stability. Cost pressures emanate from domestic labor markets (with the unemployment rate at 3 ¾ percent), the pass-through of a weaker pound to the prices of imports, and higher global commodity prices because of the Russian-Ukrainian war. As with other advanced economies, frayed global supply chains are adding to these pressures rather than providing some release, which are further complicated by the UK’s messy exit from the European Union. The BOE picked up the pace of its tightening, with a 50-basis-point hike at its recent meeting and a strong signal of more to come. Recession will test the resolve of the BOE, which has the single mandate of price stability, and all this is made more complicated by political transition that has made central bank part of the conversation.

Japan

In Japan, inflation is running above 2 percent, pushed higher by external forces given the rise in global commodity prices and depreciation of the yen. As opposed to most other advanced economies, however, inflation is only recently and marginally above the Bank of Japan’s (BOJ’s) goal. As a result, the BOJ continues to put a ceiling on longer-term yields and to keep the policy rate negative. The sustainability of this accommodation, especially its yield-curve-control element, has become increasingly doubted by market participants. This poses an event risk for global markets, but BOJ officials appear defiant, probably partly due to the looming retirement of its current governor. The weakness in global trade and concerns over China’s regional ambitions weigh especially heavily on this manufacturing-centric economy. In reflection, actual production and business confidence have softened. The recent snap election, although overshadowed by the assassination of former Prime Minister Abe, gives a firmer footing to the government and may bolster confidence.

Investment Implications

We believe there is a mutual suspension of disbelief among officials and market participants of the old, hard logic of the business cycle. Good news is good; bad news has the silver lining of foretelling a rebound. The result follows the storyline that the Fed will hew to its established policy path, slowing the growth of aggregate demand, perhaps at the risk of a shallow recession next year with few untoward consequences, and successfully return inflation to its longer-term goal. This happy coincidence would allow the Fed to reverse course and ease next year.

We believe this confidence is difficult to square with circumstances. In its latest Summary of Economic Projections, the Fed forecasts inflation to fall over the next year even as the policy rate remains negative in real terms and the unemployment rate runs below its own assessment of its natural rate. This belief in immaculate disinflation limits both the necessary projected hikes in the policy rate and adverse fallout to economic activity. It hinges on forces materializing—increased aggregate supply as people return to the labor force and global supply chains mend—that failed to materialize last fall when the Fed was similarly optimistic about imminent disinflation working from a lower base inflation rate. In our view, the latest Fed guidance represents a lower bound on the extent of eventual policy firming because inflation will persist at a higher level for longer than officials hope.

Against that backdrop, shorter-maturity yields will likely rise further, increasing the attractiveness of cash. In our view, longer-term sovereign yields are likely to rise as reality sinks in. The reality—a more persistent inflation problem and a firmer Fed—will push up breakeven inflation rates as measured by the difference between nominal and index-linked Treasury yields. The revision to investors’ outlook will be associated with elevated financial price volatility, which should extend the climb in term premiums. As economic growth slows, so too will that of corporate earnings, which will be discounted at higher market rates and prove challenging to current equity valuations. As many advanced economies teeter into recession, concerns about household, business and some sovereign balance sheets should intensify, implying that sovereign and corporate spreads widen, especially those of emerging market economies.