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Central banks forced to prioritise inflation over growth

Hamish Pepper | Posted on Mar 15, 2022
  • Inflation has risen sharply over the past year. What was initially expected to be transitory has become more widespread and persistent, with signs that price rises are being seen as the new norm.
  • The Russian invasion of Ukraine is adding to already-high global inflation, while also reducing growth prospects.
  • With inflation dangerously high, central banks (including the Reserve Bank of New Zealand (RBNZ)) are backed into a corner and are having to prioritise reducing inflation.
  • As monetary stimulus is aggressively removed, growth is likely to slow meaningfully – but this may not deter central banks until later this year.

The recent surge in energy and agricultural commodity prices represent another layer of inflation pressure for the global economy. Russia is the world’s largest energy exporter and, together with Ukraine, supplies large amounts of agricultural commodities to the global economy. Crude oil prices have increased more than 10% since the Russian invasion of Ukraine and are 34% higher year to date. Wheat and barley prices, for which Russia and Ukraine provide about one third of global supply, have increased 35% and 30% respectively since late February (see figure below). This comes on top of inflation pressures related to still-disrupted global supply chains and the ongoing recovery in demand related to the pandemic. In the latest example of supply chain issues not being fully resolved, China has locked down 17.5 million residents in Shenzhen, a key port and manufacturing hub.

Higher energy prices are a net negative for the global economy. They represent an increase in costs for households and businesses, that likely lead to lower demand. Estimates suggest global growth will be about 3.5% this year, vs. 4.0 - 4.5% previously.  


Inflation will push to new highs this quarter. Economists forecast US annual inflation to reach almost 8% in Q1, and more than 7% in New Zealand – about 1 percentage point more than they did at the beginning of the year. Markets have echoed this sentiment with 5-year breakeven inflation rates[1] increasing about 0.5 percentage points over the past month to sit above 3.5% in the US and around 3% in other developed economies (see figure below). Inflation expectations are currently well above central bank targets in most countries and are at risk of following headline inflation rates higher.

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Central banks are now forced to act to ensure inflation expectations don’t become unanchored, but this will have negative implications for economic activity. Central banks have become more determined to remove stimulus in recent weeks. They have acknowledged the various uncertainties within the economic outlook, including the Russian invasion, and the impact tighter policy settings will have on growth, but that inflation is simply too high for comfort. The European Central Bank surprised markets last week by presenting plans for a faster-than-expected reduction in bond buying. According to one person involved in the meeting “the argument about inflation dominated and prevailed over anything else, including the war, the uncertainty and the fears about growth”.

The New Zealand situation is particularly acute. With inflation expectations above the RBNZ’s 1 - 3% target band and inflation yet to peak, the central bank is expecting to take the OCR to almost 3.5%, likely using 0.5 percentage point increments in at least one of the next two meetings. Markets mostly agree (see figure below). If delivered completely, however, this risks crushing the economy. An OCR of 3.5% is more than 1.5 percentage points above the “neutral” level, the rate that neither adds or subtracts from inflation and economic activity. Consumer and business confidence is already at rock bottom. Household cashflow is being reduced by negative real wage growth, high inflation, and the sharp rise in mortgage rates. House prices have fallen 2.5% in the past three months and forward indicators (e.g. sales-to-listings) suggest further declines this year.

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We think the RBNZ tightening cycle will not be delivered completely. The current shortage of labour, however, means it may not be dissuaded from its path until rising unemployment bites and it forecasts a more acceptable path for inflation, i.e. one that more quickly returns to 2%. This is likely to generate more volatility in fixed income markets as participants attempt to balance the competing forces of high inflation and deteriorating growth prospects, while also considering the way in which the RBNZ will digest these data.

While the New Zealand market is pricing in more hikes than we expect, that is not the case in other countries. In fixed income portfolios, we are more comfortable with shorter-term bonds that capture these high OCR expectations, but are wary about longer-term bonds, which are more highly correlated with the global rate cycle.

[1] The yield difference between bonds that provide inflation protection and those that do not.

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