Foreword | After the Great Inflation — New Regime on the Capital Markets

Follo­wing the unpre­ce­den­ted tigh­tening of mone­tary policy in 2022 and 2023, both the Fed and the ECB are now back on course to cut inte­rest rates. Although infla­tion rates are still above the target value of 2%, there is justi­fied confi­dence that the battle against infla­tion has been won for the time being. Howe­ver, the posi­tive reac­tions of capi­tal market play­ers to the inte­rest rate cuts suggest that a return to the capi­tal market envi­ron­ment from before the coro­na­vi­rus pande­mic and the rise in infla­tion is also gene­rally expec­ted. This is likely to turn out to be an illu­sion. In the short term, the illu­sion lies in the uncon­di­tio­nal belief in the “soft landing” or even “no landing” scena­rio, i.e. in a conti­nuing dyna­mic growth of the US economy and corre­spon­din­gly rising corpo­rate profits. The fact that the Fed has never before in its history mana­ged the balan­cing act between fight­ing infla­tion on the one hand and preven­ting a reces­sion on the other is igno­red. What exactly the argu­ments are for the confi­dence that “ever­y­thing is diffe­rent” this time remains unclear, but will not be discus­sed in detail here. Howe­ver, the assu­med approach of the central banks is likely to play a key role, and this point is also of inte­rest from a longer-term perspective. 

We remem­ber

The capi­tal market envi­ron­ment of the past 15 years (up to and inclu­ding 2020) was charac­te­ri­zed by central banks’ willing­ness to combat exter­nal shocks by provi­ding virtually unli­mi­ted liqui­dity, whether by cutting inte­rest rates into nega­tive terri­tory or by vastly infla­ting their balance sheets through the purchase of secu­ri­ties. The welcome side effect: the flood of liqui­dity had a posi­tive effect on the capi­tal markets and signi­fi­cantly weak­ened the link between the econo­mic situa­tion and the perfor­mance of the indi­vi­dual asset clas­ses. Howe­ver, a key condi­tion for the central banks’ actions was the absence of infla­tio­nary risks — the central banks were able to concen­trate on comba­ting all possi­ble crises without having to fear rising infla­tion. This chan­ged funda­men­tally after the coro­na­vi­rus pande­mic, when the contin­ued injec­tion of liqui­dity ensu­red that over­all econo­mic demand remained high, even though there were considera­ble supply bott­len­ecks at the same time. This was the real reason for the rise in infla­tion, which was further fueled by drasti­cally rising energy prices as a result of the Russian inva­sion of Ukraine. 

Let us now look to the future

There are at least three reasons for struc­tu­rally higher infla­tion in the coming years: Firstly, the chan­ged geopo­li­ti­cal situa­tion and, in parti­cu­lar, the syste­mic rivalry between the US and China. Even if two compe­ting blocs and the asso­cia­ted isola­tion from each other do not emerge, global trade in the future is likely to be deter­mi­ned more by poli­ti­cal power strug­gles and not prima­rily by the econo­mic advan­ta­ges of the global divi­sion of labor. The disci­pli­nary effects of globa­liza­tion on wages in the indus­tria­li­zed count­ries will ther­e­fore dimi­nish, espe­ci­ally as China has shed its status as a low-wage coun­try and it is the poli­ti­cal will of the leader­ship there to supply the global markets not thanks to lower produc­tion costs, but as a result of its own tech­no­lo­gi­cal supe­rio­rity. In addi­tion, compa­nies and count­ries will try to reduce their vulnerabi­lity to exoge­nous shocks. Resi­li­ence will ther­e­fore become more important than the most cost-effec­­tive solu­tion. Secondly, the demo­gra­phic trend favors struc­tu­rally higher infla­tion rates. Years ago, Charles Good­hart chal­len­ged the prevai­ling view that demo­gra­phic change has defla­tio­nary effects due to its dampe­ning effect on poten­tial growth. The crucial point is that the demo­gra­phic trend will result in a drama­tic shortage of labor, which will have a massive impact on the current decade. The expec­ted econo­mic conse­quen­ces are higher wage increa­ses and ther­e­fore higher costs for the produc­tion of goods and services. Although migra­tion could dampen this effect, the poten­tial for skil­led immi­grants is likely to be far too small to prevent an increase in wage costs, given simi­lar deve­lo­p­ments in many emer­ging count­ries. Thirdly, the ecolo­gi­cal trans­for­ma­tion of natio­nal econo­mies will require enorm­ous invest­ment in the coming deca­des, parti­cu­larly with regard to climate protec­tion. As this will essen­ti­ally replace the exis­ting capi­tal stock for energy produc­tion without directly incre­asing output, the invest­ments can only be finan­ced through higher prices. These three infla­­tion-incre­a­sing factors are coun­te­red by a poten­ti­ally weighty argu­ment: produc­ti­vity increa­ses that are expec­ted from digi­ta­liza­tion and in parti­cu­lar from the rapid deve­lo­p­ment of AI could signi­fi­cantly dampen infla­tion. In prin­ci­ple, this seems enti­rely conceiva­ble, but the old adage that the produc­ti­vity gains of new tech­no­lo­gies are unde­re­sti­ma­ted in the long term but usually signi­fi­cantly overe­sti­ma­ted in the short term also applies here. As the produc­­ti­­vity-enhan­cing effect of AI depends cruci­ally on the conver­sion of entire busi­ness models, it is plau­si­ble to assume that this will take some time. This poses a dilemma for the mone­tary policy of central banks. On the one hand, infla­tion will play a much grea­ter role in their actions than in the first two deca­des of this century. The gene­ral inte­rest rate level will ther­e­fore not fall back to zero, but will remain perma­nently high, and phases of rising inte­rest rates to curb exces­sive infla­tion will once again become the norm in mone­tary policy. 

On the other hand, howe­ver, central banks are confron­ted with persis­t­ently high levels of govern­ment debt, which the capi­tal markets incre­asingly perceive as unsus­tainable. This could result in enorm­ous insta­bi­lity on the finan­cial markets, espe­ci­ally if the USA, as the anchor of the global finan­cial system, is also affec­ted. In view of the USA’s latent loss of importance and dome­stic poli­ti­cal tenden­cies towards isola­tio­nism, this is a perfectly plau­si­ble scena­rio. The central banks could coun­ter the risk of syste­mic insta­bi­lity by capping inte­rest rates, although this would entail risks in terms of comba­ting infla­tion. This means for play­ers on the capi­tal markets: Brin­ging infla­tion back to a level of around 2% does not at all mean a return of the previously exis­ting envi­ron­ment. Rather, we are ente­ring a new regime: Mone­tary policy will fluc­tuate more between oppo­sing poles and will ther­e­fore be subject to grea­ter “unpre­dic­ta­bi­lity”, econo­mic cycles will be more prono­un­ced and possi­bly shorter, and the perfor­mance of indi­vi­dual asset clas­ses will not follow clear trends for longer peri­ods of time, but will exhi­bit more prono­un­ced vola­ti­lity. Inte­rest rates are likely to remain clearly posi­tive, but with an over­all upper limit. The winners in the coming years will be those play­ers who are best able to adapt to this. 

Axel D. Angermann