Why advisors can't afford to rule out central bank mistakes

Policymakers are struggling to contain inflation amidst growing energy concerns

Why advisors can't afford to rule out central bank mistakes

Today’s economic turbulence may be far from over, said one economist, especially since one of the biggest challenges facing central banks now is the inflation overshoot.

“That is challenging central banks because it’s something that none of them predicted,” Robert Lind, Capital Group’s economist, said. “They’re only partially really understanding why inflation has overshot as much as it has.

“I think they’re also cognizant of the fact that policy has been left too loose for too long. We now see the increasing risks around energy prices, particularly in Europe given the concerns around disruption of the energy supply.”

The combination of demand and negative supply shocks is challenging policymakers and central banks, particularly since they’ve been used to low inflationary pressure over the last few years.

“This is generating much weaker economic growth than we expected six to nine months ago,” said Lind. “That’s coinciding with much higher inflation. I think, for the time being, central banks, particularly the Fed, but increasingly the European Central Bank, are going to focus on the inflation element of that problem, which is why they’re saying they’re going to tighten monetary policy over the next few months. They’re keen to get interest rates back up to something more neutral.”

Lind doesn’t believe the banks can completely ignore the fact that the growth numbers are starting to soften. So, while he doesn’t believe there’ll be a recession in the next year or so, he said, “I think the odds have gone up and will go up as central banks continue to tighten.”

Capital Group expects to see more reverberations of higher oil and energy prices. Given that the Russian war on Ukraine is continuing, he’s also expecting more supply disruptions from Russia. That could have a significant risk for the European economy, and further impact prices, particularly food, pushing up inflation as well as weakening European economies. He said gas rationing, particularly for heavy industrial users, may be necessary.

“It would be temping to say, maybe this will last for a few months, and then we can go back to normal,” said Lind. “But, this is likely to be a long term structural change.”

He said the shift from European economy relying on cheap Russian gas impacts raises questions about the longer-term prospects of the European economic model Germany, for instance, has been using cheap Russian gas to produce exports to sell to China. So, there are questions about how European policymakers will respond.

“The longer the war in Ukraine drags on, the more likely it is that we’ll see significant collateral damage beyond Ukraine’s borders, across Europe, and into the rest of the world economy,” said Lind.

“Given the scale of the shocks, we shouldn’t rule out the fact that policymakers will make mistakes,” he said. “Over the last 20 years, it’s been relatively easy to run macro policy. But, given the scale of the shock, it’s a much harder way to run the economy. That increases the likelihood that we’ll see much greater turbulence and volatility in the underlying macro economy, but also, more importantly, in asset prices, which will be very important for financial markets.”