Q2 2023 Cash Outlook – Battle of Perceptions

Unless the market perceives that central banks are doing their job of raising interest rates until they squash inflation, they lose credibility, and with that loss comes the increased possibility that inflation persists. Labor markets remain the challenge for central bankers not only in the near term but also in the long term due to demographic shifts and immigration.

If history is any indication, central banks will inevitably be blamed for all the hardship they caused rather than for all the good they did. It would be nice if they could engineer a soft landing. We would like that; they would like that; but that is very hard to do. The more persistent inflation is, the higher policy rates must be, and the more likely something will “break” in the economy and cause a hard economic landing.

Former Chair Ben Bernanke explained the US Federal Reserve’s (Fed’s) decision to pause at the end of the long hiking cycle in 2006 by saying that the Fed should execute policy based on two definitions of Fed credibility. The first, which he termed “Volker Credibility,” is the willingness to do whatever is needed to return inflation to 2%. The second, which he called “Greenspan Credibility,” is the desire to fine-tune policy and avoid causing undue harm to the economy while bringing inflation down. Certainly, Alan Greenspan attempted the latter, but his tenure saw some challenges (Lincoln Savings and Loan fiasco, and Dot Com meltdowns, and he managed to retire just before the biggest of them all).

At the moment, it appears developed markets might be able to engineer a soft landing. We have begun to see a decline in inflation data in Europe, and the US, too, has started to see a trend toward lower inflation readings. But the labor market remains the challenge for these central bankers. With such a tight labor market, it could be very challenging to generate the “demand destruction” that is needed to slow the pace of price increases.

A further tightening of credit conditions could be seen as quasi-hiking of rates. Central bank rhetoric has dragged some sovereign rates higher, but it has been a battle to pull those yields up. The rates market seems convinced that the same central banks that are talking tough on inflation and telling us rates will be higher for longer might also ease their policy rates in the not-too distant future. And credit markets appear to be stable and the spreads are consistent with a mild recession or even no recession.

There is no doubt that central banks will win the fight against inflation eventually . It is simply a matter of time until they generate demand destruction. The aim is to push interest rates to a point where businesses can no longer be profitable and thus need to shrink their output and labor force – these layoffs will change consumer spending. But, in my opinion, consumer spending may change only at the point of job losses. If the consumer is employed and has seen wage gains, he/she is able to afford (or believes he/she can afford) the higher cost of goods.

The probability of a soft landing will decline with more interest rate hikes. If the Fed were to forgo future rate hikes, it might be able to engineer a soft landing. But the further it goes, the more likely it is to break something. Its challenge remains one of perception vs. reality. Leading indicators (Figure 2) show that the economy is slowing. If you pulled the Fed Chair Jerome Powell into a quiet room with no one listening, he may tell you he is confident that inflation will fall back to the 2% target. Leading indicators are telling him this. But he is working against a clock and that clock measures his credibility. Unless the market and general public perceive that the Fed is doing its job of raising interest rates until it squashes inflation, it loses credibility, and with that loss comes the increased possibility that inflation persists. It has to make us believe that a recession is coming so we change our spending habits.

Demographics could be a major headwind in the long term in that we have seen a growing shortage of workers over the past 20 years. In the US, a decline in the labor force participation rate has been evident since 2000 (Figure 3). Since the beginning of the 1980s, there had been a growing supply of global labor. China, the best example, was slowly becoming the manufacturer of the world. Supply chains from Asia to Europe and the US were consistent and growing, and wage deflation and goods deflation were present. Now the dynamic has shifted. Aging populations and a declining workforce have put the workers in a better position to ask for higher wages and better working conditions. This new dynamic could be in place for years to come (Figure 4).

As the world ages, the shortage of workers could become a larger problem. The average age of the G10 countries is between 38 and 49; the average age of some of the sub-Saharan African countries is between 18 and 22. Many developed nations may need to rely on immigration to help support the economic output necessary to afford the largest generation of retirees the world has ever seen. There is a huge demographic imbalance that exists in the world and it may only be solved by migration. Countries may need to make themselves attractive for these workers. They will need to acclimatize immigrants to the local culture. Without a smooth incorporation of new labor into the market, there could be social disruption, and maybe civil unrest.

Canada will be an interesting country to watch in the coming years. It has a very favorable immigration policy and it is generally understood that it will “immigrate” its way out of the demographic challenge. Accepting as many as 1 million new immigrants each year, Canada’s population has just pushed past 40 million and could pass 100 million by 2100. However, with fast population growth comes a number of challenges. In an already hot housing market, shortages are acute and have caused a spike in building material inflation. At the current rate of immigration, some experts worry that the country’s ability to properly distribute these new workers could be a challenge. Already strained cities are at capacity; the rural areas in need of labor must make themselves attractive so their populations grow.

As for rate expectations for the second half of the year, it appears that we may see the turning point. The Fed, by its own estimates, is expected to raise rates by another 50 bp, the European Central Bank by another 50 bp, and the Bank of England by another 50–100 bp. Economies are expected to push into recession; some are of the mind that the UK and Germany are already there. The US recession has been pushed into 2024 by most economic estimates. All this leaves cash markets anticipating the pivot. Once burned twice shy? I think so. We have seen this narrative before. Risks remain that central banks may have to do more and not less in the coming months – unless, of course, they happen to break something as they have been known to do.