A year ago, most economists expected that the Covid-19 pandemic would continue to weigh heavily on the global marketplace, and that the recovery process would be far from smooth. But two changes to the landscape — rapid inflation, and questions about the viability of investing in China — caught nearly everyone off-guard.
Even if we had foreseen these developments, it is unlikely that we would have gotten right their broader implications. And we probably wouldn’t have guessed that markets would by and large take the news in stride. That bears remembering as we attempt to make projections for the coming year while still dogged by the pandemic and other uncertainties.
The Inflation Surprise
I know of no forecaster who came close to projecting a nearly 7% U.S. inflation rate for the end of this year, and that includes those of us who pushed back as early as six months ago against the notion that this bout of inflation would prove to be transitory during 2021.
Today, unusually high and persistent inflation has become the consensus call. Yet even now, there is an under-appreciation of the current inflation dynamics, including supply-chain disruptions and worker shortages associated with the new Covid variant, omicron.
The surge in inflation is even more striking given that, unlike what textbooks and prior experience would suggest, its impact on markets has been muted.
Yields on government bonds, for example, have been relatively subdued, with 10-year U.S. Treasury notes still trading around 1.50%. Indeed, if anything, yields adjusted for inflation have fallen deeper into negative territory. Meanwhile, stocks have gone from one record high to another, reaching a total of 70 for the S&P 500 Index this year.
This makes the new year an uncertain proposition for the economy, for markets and for public policy.
Will inflation derail economic growth while also worsening inequality? How long will it take for the Federal Reserve to catch up to inflation realities, and which policy measures will it deploy?
How quickly will a tightening of market financial conditions follow the pivot to fewer stimulus policies from central banks? How big will the economic and financial impact be, in the U.S. and across the world?
Will yields rise as bond investors look to limit the erosion in the real value of their investment? If so, how will stocks react?