Inflation will not moderate, it is a runaway train Inflation will not moderate, it is a runaway train Inflation will not moderate, it is a runaway train

Inflation will not moderate, it is a runaway train

Steen Jakobsen

Chief Economist & CIO

Summary:  There is a great need in the human psyche for normalcy and predictability. This is what investors and policymakers have been hoping for since the chaos unleashed by the pandemic, followed by the war in Ukraine.


There is a great need in the human psyche for normalcy and predictability. This is what investors and policymakers have been hoping for since the chaos unleashed by the pandemic, followed by the war in Ukraine. But the current brutal pace of change and volatility is here to stay for now. Don’t expect any return to moderation or calm over the rest of 2022, or for some time thereafter for that matter. 

This outlook addresses how the economy and markets react when undergoing a paradigm shift from high economic visibility and low inflation to one of high volatility and high inflation. And we are talking about a real paradigm shift, really the first of its magnitude in modern history since President Carter and Fed Chair Volcker did in the late 1970s what President Biden and Fed Chair Powell are trying to do today—kill inflation. Back then, the task was somewhat easier, given a young population and low leverage in both the public and private sectors of the economy. Now we have an older, asset-rich private sector and a massively indebted public sector. Spoiler alert: it won’t be easy. 

The last two decades of endless policy support have served investors well, as the main macro policy has been one of infinite monetary easing at every stumble and plenty of countercyclical fiscal stimulus. The buy-the-dip mentality prevailed and was rewarded at every turn, as policymakers continued to increase the ‘speed of the train’—the quantity of money feeding into the economy—with no or negligible impact on goods inflation due to the labour and cheap energy arbitrage of globalisation. This, even as asset inflation raged due to the rising leverage driven by ever lower policy rates. 

‘The great moderation’ was the narrative of the time, and former Fed Chair Bernanke went out of his way to boast that the standard deviation of quarterly GDP had halved and inflation had declined by two-thirds during this period. In other words, the economy was supposedly becoming ever more predictable and less volatile, not recognising that it was a one-off process allowed by ever easier policy rates, hidden leverage and globalisation. The seemingly endless cycle of being able to simply ease at every speed bump in the economy or markets even allowed us to indulge in the fantasies of Modern Monetary Theory (MMT), which claimed there is no real hindrance to simply printing money for fiscal stimulus. 

But the final phases of the rinse-and-repeat of policy stimulus aggravated growing imbalances, as policy rates began falling below realised inflation. This resulted in deepening negative real yields, which became necessary to continue to fuel the rise of asset prices but which also brought weak capital returns, as negative real rates drove increasingly unproductive investment.  

Over the last two decades, we have created an economy and society where the financial part of the economy kept growing at the expense of the ‘real economy’ of physical goods and activity. Simply put: the real economy became too small in relative terms, something that was made suddenly and painfully clear in the wake of the pandemic outbreak, when the enormous push generated from the financial economy to sustain demand fed straight into inflation. That’s because the physical economy, the supply side, could not come close to meeting a stepwise shift higher in demand. That was in part due to the shutdowns limiting production, but also as the long-term underinvestment in energy infrastructure and the dream of shifting to far more expensive alternative energy meant that the physical world simply couldn’t keep up. 

At its recent extreme low during the pandemic outbreak phase, the energy component of the S&P 500 fell below 3 percent of the index’s market cap. This at a time when the five most valuable companies, all from the digital financial world, were worth more than 25 percent of the index. Meanwhile, pension funds, sovereign wealth funds, asset managers and even governments (Sweden and Finland) banned investment into fossil energy due to environmental, social and governance (ESG) mandates, despite this energy driving the bulk of the economic activity upon which our daily life is based. And then the Russian invasion of Ukraine added fuel to the flames.   

This brings us to today and our core outlook for the second half of 2022. Central bankers continue to peddle the idea that ‘normalisation’ to around 2 percent inflation target is possible within an 18-month horizon. But why should we listen when these same people never conceived that inflation could reach above 8 percent in both Europe and the US? The risk is that inflation expectations are rising fast and driving second-round inflationary effects that will require central banks to tighten even more than they or the market currently conceives until the runaway train is controlled, likely sending us into a deep recession.  

This creates the next macro policy change and response we will need to look for in Q3 2022. Given a policy choice of either higher inflation or a deep recession, the political answer will likely be to instruct central banks directly or indirectly to move the inflation target up from 2 percent. The optics of this would hopefully mean requiring a bit less tightening, but also that negative real rates, or financial repression, are a real embedded policy objective now. It’s also a risky bet that there is some Goldilocks-level of demand destruction from a higher policy rate that will start to force inflation lower, all while demand is subsidised for the most vulnerable with support schemes for power, heating, petrol and food. The holes in this policy argument are that none of this addresses the imbalances in the economy. Whether the Fed has a 2 or 3 percent inflation target does not create more cheap energy. What is clear is that the political system will favor the ‘soft option’ for inflation in which the chief imperative is financial repression to keep the sovereign funded and a reduction of the real value of public debt via inflation. This is exactly why inflation will continue to rise structurally. Q3 and beyond will make it clearer that political dominance pulls far more rank in the new cycle than monetary tightening, which will forever chase from behind. The great moderation is dead—long live the great reset. 

Explore products at Saxo
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.