Markets signal a kind of pyrrhic inflation victory

Inflation almost seems passe. The worry of the moment is now economic growth. That’s not unreasonable, as the latest update shows US gross domestic product declined at an annualised rate of 1.6% in the first quarter. With the huge exceptions of the Covid-scarred first two quarters of 2020, this was the weakest US growth since the spring of 2009.
That has had the effect of seemingly eliminating concerns about inflation, even though the battle against it has barely begun. Breakevens, derived from yields on inflation-linked bonds, have dropped all around the world. The 5-year, 5-year forward breakeven, which aims to capture average inflation for the five years starting five years hence and is the measure most closely followed by the Federal Reserve, has now dropped below its level from much of 2018, before the pandemic. Fast approaching the Fed’s target of 2%, the bond market is saying that inflation is no longer anything to worry about.
The problem is that inflation forecasts have shifted because growth forecasts are also shifting. With a recession now named as a base case for many next year, the belief is gaining greater hold that the Fed will hike rates by a further 2 percentage points, but then swiftly start cutting again. The easing cycle, if you believe the Fed funds futures market, will be well advanced by the end of next year. Over the last week, the belief in a swift start to easing has gained a hold — and that, sadly, is because pessimism about the economy has also taken hold.
Even if the markets are confident that inflation is as good as beaten already, however, central bankers are being careful not to seem complacent. The European Central Bank’s annual summit at Sintra in Portugal featured a panel involving Agustin Carstens, Jerome Powell, Christine Lagarde and Andrew Bailey, heads of the Bank of International Settlements, the Fed, the European Central Bank and the Bank of England. None was prepared to divert from the message that inflation was the overriding priority. Powell asserted that the Fed was “committed to, and will succeed, in getting inflation down to 2%,” and that to do otherwise would cause more pain — a sentiment fully endorsed by the other central bankers.
A less diplomatic way to make that point: It might be necessary to force a recession to get rid of inflation, but the recession that would result from letting price pressures take deeper root would be even worse. That’s the message the market took. At this point, obdurate inflation, forcing rates up to 4% and beyond, definitely isn’t priced in. At the macroeconomic level, the most painful surprise over the second half of this year would be for inflation to stay sticky. That would quash the belief in a swift easing campaign in 2023.
There’s been much talk of “inverse currency wars” as different central banks strive to gain a strong currency to help them deal with inflation (rather than a weak one to boost export competitiveness). It doesn’t seem to be happening. The dollar is strengthening, and nobody seems prepared to crimp its style.
Powell made clear that he wasn’t bothered by a strong dollar, which does after all tend to be deflationary. Frederik Ducrozet, head of macroeconomic research for Banque Pictet & Cie SA, commented that Powell seemed to acknowledge the US was lucky to have a relatively closed economy. “He was looking at Lagarde as if to say he had secret sympathy for the restraints they are working under.” That didn’t, however, prompt Lagarde to make any comment about the euro.
Couple that lack of concern with continuing intention to keep hiking rates and that added up to another rally for the dollar when compared to other major currencies in the widely followed dollar index.

—Bloomberg