A Stagflationary Shock

Key Points

1. A stagflationary shock

The Russian invasion of Ukraine may spell higher prices and lower growth for the global economy—increasing downside risks to markets and heightening central bank policy uncertainty.

2. The vaccination for inflation?

Central banks have prescribed a regiment of rate increases and the end of QE to stop the spread of inflation, but the dosage may not be adequate to protect against its many variants.

3. Expanding return sources

Rising political tensions make the Fed’s fight with inflation even more tenuous. New sources of diversification and return may be needed as inflation undermines the traditional diversifying properties of bonds.

The U.S. Federal Reserve’s (“Fed”) pivot away from the view that inflation is “transitory” signaled the beginning of the end for the ultra-low rate environment we have come to think of as normal.

Financial markets reacted to this new information by aggressively repricing shorter-term interest rates to start the year. The exit from these policies now appear well priced-in for the U.S. as yield curves have flattened to levels typically associated with the end of a tightening cycle. Investors are now debating the terminal rate and what happens if inflation does not fall as much as consensus and the Fed expects.

It looks almost certain that the Fed must end the era of quantitative easing (“QE”). Was QE a success? We must wait for quantitative tightening (“QT”) to see. The ultimate judge of more than a decade long experiment in unconventional policies lies in how the Fed can balance its conflicting objectives of maximum employment and stable prices without fully knowing how financial conditions will respond.

Past inflationary cycles rarely end well for financial markets. The Russian invasion induced spike in commodity prices holds the potential to further exacerbate what might already be in train: a wage-price spiral. The risks surrounding this scenario have clearly increased and a more cautious outlook for this downside possibility is increasingly warranted.