Returning inflation to target without adverse recessionary consequences hinges on the supply of goods and services returning to normal.

Inflation: monetary policy can’t engineer a soft landing by itself (afr.com)

Global inflation prints are recording levels not seen in 40 years, and inflation expectations are rising. If policymakers rely solely on higher interest rates to bring inflation back into the target band, the economics tell us it will require a sizeable reduction in aggregate demand, and equity markets are in for more pain.

Economists are forever trying to understand the economy with intricate models. But economies are complex, and it is fair to say that the very brightest minds and best models have been puzzled by the lack of inflation over the past decade and totally blindsided by the sudden rise in prices since the start of 2021.

Sometimes the simplest explanations are the best. The textbook demand and supply diagrams from Economics 101 can explain much of what investors need to know over the past two years. The pandemic and policy response had two discrete impacts on market equilibrium and stable prices – shifting the supply curve to the left and the demand curve to the right. When this happens, the market clearing price shoots higher for the same level of output.

Aggregate demand was excessively stimulated though massive government spending during the pandemic. While households did need some support during lockdown phases, the quantum of spending in major markets caused a surge in household savings and has held aggregate demand at elevated levels.

COVID-19 had well-publicised impacts on global supply chains. Lockdowns and enforced isolation have severely affected the ability to provide much of the goods and services we need. But what happened to price rises being transitory? Labour supply and mobility is not quickly returning to pre-pandemic levels. The invasion of Ukraine has put pressure on energy and soft commodity supply, while many other resources are supply constrained after years of under-investment.

Central banks, including the Reserve Bank of Australia, now appreciate that the increase in demand and slower supply risk a more persistent increase in inflation as expectations get anchored at higher levels.

We know that central bankers can crush demand whenever they want – so the soft-landing scenario depends heavily on global supply chains improving. Without a meaningful supply response, aggregate demand will need to fall some way to get demand and supply back into balance at lower prices.

Varying forecast abilities

Many private investors make the mistake of trading how they currently see the economy. Professional strategists will confidently tell you that equity investors are always pricing six months out – but their ability to foretell the future and the confidence intervals around their forecasts vary immensely.

The US S&P 500 index started the year at 4766 – effectively pricing in $US226 dollars of earnings for the market at a multiple of 21.1 times. But as central banks changed their tune, and bond yields rose, the US equity market fell 23 per cent as the price earnings multiple derated from 21 to 17 times. Expectations about corporate earnings have remained relatively resilient.

Late June saw bond yields move a little lower and equities recover some lost ground. After strong first-quarter S&P500 earnings growth of 11 per cent, the second-quarter reporting season is about to start. Outlook statements and margins will be heavily scrutinised. Earnings growth is expected to moderate to a more modest 5 per cent growth, but still be underpinned by strong energy, materials and industrials earnings. Any disappointment on earnings is likely to see the market move lower.

The central bank “put” – where the Fed or the RBA rolls in to save equity markets from falling too far – has gone. In an environment where policymakers are focusing on tackling inflation and discounting the impact of falling corporate earnings, the equity gains for 2020 and 2021 could be wiped out.

If supply does not respond and corporate earnings forecasts for 2023 fall back to 2019 levels, the end-year target for the S&P 500 would be as low as 2805, 41 per cent below the start of the year.

So while central banks will do their bit to lower demand and create a soft landing, the real ability to return inflation to target without adverse recessionary consequences hinges on the supply of goods and services returning to normal.

Let’s hope that supply responds quickly and we don’t get another case of the “recession we have to have” to get inflation back under control.