U.S. monetary policy may hinge on structural inflation with asset price reset underway

NEW YORK, Nov. 22 (Xinhua) -- The U.S. monetary policy in 2023 could largely depend on whether structural inflationary pressures allow U.S. inflation return to the 2 percent target, economists have said.

The Federal Reserve would face a different tradeoff between inflation and economic growth. Meanwhile, the removal of liquidity from the system is causing huge reset of asset prices, which is not expected to end soon, they have said.

STRUCTURAL INFLATIONARY PRESSURES

Both U.S. consumer price index (CPI) and producer price index for October posted obvious decline, but economists remain concerned about uncertainty from structural inflationary pressures.

There is a secular change in supply constraints and supply conditions in the global economy with lower supply elasticity and non-transitory inflationary pressures, said Nobel Laureate in Economics A. Michael Spence.

The exhaustion of the potential to tap into unused and productive resources and aging in major countries are among the contributing factors to the declining supply elasticity, said Spence at The Chinese Finance Association (TCFA) 28th Annual Conference on Nov. 13.

At least for the next two or three years, persistently high energy costs will mean that there will be supply constraints in the downstream including petrochemicals and fertilizer,said Ray Farris, chief economist and chief investment officer for the Americas, Credit Suisse.

"So the entire economy is, in a sense, more inflationary ... we are probably in a higher inflation type of regime or more volatile inflation type of regime," said Farris in a panel discussion at the TCFA meeting.

"We do believe the path of inflation coming down ... We've been actually saying that for the past couple of months, inflation is peaking and the Fed hawkishness is peaking," said Charles Tan, co-chief investment officer on global fixed income and senior vice president with American Century Investments, at the TCFA meeting.

Then the key question becomes how long the Fed stays at the higher terminal rate, and how long it would take for the inflation to come down, Tan added.

While there is consensus that inflation will come down, "the question is where is inflation going to land at the end of 2023 and that has some level of uncertainty. And that obviously will have an impact also on central banks, how they react and ultimately that can drive the economy," said Themis Themistocleous, chief investment officer for Europe, Middle East, and Africa (EMEA) at the UBS, during an online roundtable meeting recently.

Falling inflation should allow central banks in the United States, the EU, Swiss and Britain to complete their hiking cycles in the first quarter (Q1) of 2023 or the second quarter (Q2) of 2023 at the very latest, according to the UBS.

Inflation in the United States and Europe are likely to be close enough to the 2 percent year-on-year target toward the end of 2023 for rate cuts to be considered, said the UBS in its outlook report for 2023 released recently.

TRICKY BALANCE, TRADEOFF

The Fed has been in the process of striking a balance in driving down inflation but avoiding recession for a few months. Moreover, the central bank could find it even trickier to find a tradeoff between inflation and growth in the coming months.

The Fed was late to the game in fighting inflation, which makes it more difficult to find the balance, said Spence at the TCFA meeting.

It's very difficult for a central bank to know when it has done enough in terms of tightening monetary policy due to the lag effect of monetary policies, said Spence.

Although the housing market started to cool down with house prices coming down and mortgage rates going up, "that doesn't answer the question whether it's enough," he said.

Though the U.S. inflation fell from historic highs but if it gets stuck at 4 percent or 3.5 percent, "rather than falling back to the 2 percent target, how is the Fed gonna react?" said Mark Haefele, chief investment officer with UBS Global Wealth Management, during the above-mentioned online roundtable.

It took 16 months for the U.S. inflation measured in year-on-year CPI growth to peak in June this year and it likely takes another 16 months to fall to about 3 percent in October, 2023, according to a recent report by U.S. brokerage and investment banking firm Stifel.

"CPI and personal consumption expenditure will fall without the need of a recession, making this Fed's quest for redemption the greater risk," said Barry B. Bannister, head of institutional equity strategy with Stifel, in the report.

"I think that is something that nobody really knows the answer to, given that we've thrown out all the economic textbooks and engaged in fiscal and monetary policy we've never seen before," Haefele said.

Inflation is ultimately a policy choice and if the Fed chooses to be committed to a target of 2 percent, it can achieve that target, said Farris in an interview with Xinhua on Nov. 13.

What the change in the structural balance background including less globalization, less supply of energy, deterioration in demographics means for the central bank is "that in order to achieve its inflation objective, the trend rate of growth is going to be lower," Farris said.

"If I'm committed to an inflation objective, I can achieve that inflation objective. But, I may have to accept less growth than in the past or than I desire...There's a trade off," he said.

"HUGE ASSET PRICE RESET"

The aggressive monetary tightening led by the Fed has caused a deep fall of growth stocks and crypto currency prices in addition to big swings of foreign exchange rates so far this year.

"We are in the midst of a huge asset price reset," said Spence on the dynamics and uncertainties in the market.

The new interest rates won't be temporary and many stocks in general are just going to have lower valuation in the future, said Spence.

Investors are going to emerge from this difficult environment with a kind of new equilibrium, new interest rates, new asset values and probably healthier valuations in many areas, he said.

Crypto coins and special purpose acquisition companies (SPACs) have been a source of a lot of the speculative froth in markets at the beginning of 2022, according to Haefele.

"That's coming out now. So it's another symptom of the kinds of things you see when the liquidity tide rolls out and when the central banks start pulling out that liquidity," he said, referring to the shrinking valuation of crypto coins.

U.S. inflation has peaked and equity and bond returns historically tend to improve after that, said Farris.

"But going forward, because the Fed is still increasing interest rates, it's not so clear that that improvement in returns will come quickly. It could take longer. I think the outlook is probably better, sooner for bonds than it is for equities," he said.

"The reason that equities may struggle over the next six months is that the Fed is still raising rates, growth is slowing and the risk of recession is going to remain very high," he added.

Nevertheless, lower valuation may provide a healthier environment for continuing long-term transformations.

A more positive secular backdrop remains possible, and lower asset class valuations favor stronger returns for diversified investors, with a transition to greener energy, the era of security, and digitalization remaining key drivers, said the UBS.

The world is undergoing major transformations like digitalization, material science revolution and energy transition, Spence said.

"Investors will find lots of interesting investment opportunities, not only the volatility and the stress that's created in the transition like this, but also a kind of healthy evaluation environment with respect to lots of things that really do have enormous potential, especially in these technologies associated with major transformations," he added.