We heard from three central banks this week: the Reserve Bank of New Zealand (RBNZ), the Bank of Canada (BoC), and the European Central Bank (ECB). The first two hiked by 50 bps, the latter of course kept rates steady. All three warned of the same thing: the risk that people begin to think that the current high level of inflation will last for a long time. They said as follows: RBNZ:  The Committee will remain focused on ensuring that current high consumer price inflation does not become embedded into longer-term inflation expectations. BoC:  There is an increasing risk that expectations of elevated inflation could become entrenched. The Bank will use its monetary policy tools to return inflation to target and keep inflation expectations well-anchored. ECB:  While various measures of longer-term inflation expectations derived from financial markets and from expert surveys largely stand at around two per cent, initial signs of above-target revisions in those measures warrant close monitoring. It is true. Inflation expectations in the three currency zones are indeed rising. Why are they so worried about this? Because economists believe that if people start to think that inflation is going to be higher in the future, they’re going to demand higher wages to make up for it. Then companies will raise their prices to cover the higher wage costs and the fears will become true – prices will rise faster. Which will just encourage people to demand a bigger hike in wages at the next negotiating round. In other words, the fear is that rising inflation expectations can set off a wage/price spiral that makes it hard to tame inflation. Furthermore, economists worry that if companies expect inflation to remain high they are likely to keep raising their prices so that they can cover the cost of replacing their inventory, or even just take advantage of generally rising prices to raise their prices too (“me-too” price hikes). The question is, is there any basis in fact for these theories? Some economists say no. A recent paper by an economist working for the Board of Governors of the Federal Reserve (“Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)”) argued that “history really only tells us that lags of actual inflation seem to enter inflation equations to a greater or lesser degree over time, not that expectations do or did; thinking that these lags of inflation are present because they are a proxy for some kind of forecast is more a habit of mind than anything solidly grounded in fact.” He concludes, “…we have nothing better than circumstantial evidence for a relationship between long-run expected inflation and inflation’s long-run trend, and no evidence at all about what might be required to keep that trend fixed…” A recent paper prepared for the European Parliament’s Committee on Economic and Monetary Affairs (ECON committee) (Should rising inflation expectations concern the ECB?) agreed. It argued that “There is limited evidence of survey measures of inflation being useful for forecasting inflation.” “The traditional wage-bargaining mechanism through which expected inflation should raise inflation is likely to be weak in a world with low levels of unionization,” it said. It also noted that “Central bank efforts to influence the public’s inflation expectations may be limited in usefulness. Most people pay no attention to central banks and many have poorly informed opinions on inflation.” A similar conclusion from another paper in that series (What to expect from inflation expectations: theory, empirics and policy issues). “The overall picture of theoretical and empirical studies is more shadowed than usually believed,” it said. “Granted that information on future inflation expectations has to be carefully assessed and processed along with other information… caution suggests it should not be given the role of polar star of monetary policy.” In short, central banks seem to be placing a lot of importance on something that may not actually be particularly important. Given the leads and lags in forming inflation expectations and the stickiness of people’s views once they’re established, this could lead central banks to make a policy mistake on the upside and plunge economies into a recession to stamp out something that doesn’t matter. In any case, inflation expectations seem to me to be largely a function of oil prices so I’m wondering what the big deal is anyway. One thing that may be helping to push up inflation currently is not high wage settlements as the “inflation expectations” theory would predict but rather corporate greed. If we look at the companies in the S&P 500 and Dow Jones Industrial Average, their profits margins are the highest in at least 32 years. (I don’t have data before that.) If we look at profits as a percent of GDP, in Q3 last year they tied the Q1 2012 record of...

Outlook: We can attribute the dollar’s gains to the usual suspect—divergence in monetary policy that widens the current and expected yield differential. The Fed delivered yet another policy member, NY Fed Pres Williams, affirming the May hike will be 50 bp. At the same time, the ECB delivered no fresh words, policies or guidance. This was expected, but apparently disappointed anyway. Elsewhere, China cut reserve requirements by 25 bp, a smallish move compared to lowering lending rates. This comes ahead of Q1 GDP and the other monthly data dump from China on Monday. Bloomberg warns “the data will likely show a pickup in growth that masks a major setback toward the end of March, when lockdowns in Shanghai, Shenzhen and elsewhere clobbered the economy.” This leaves the world with two major economies either cutting rates or holding to an accommodative stance (curve control in Japan that caps the 10-year at 0.25%) compared to Europe with “no change” and the US, UK and Canada/Australia/New Zealand on the higher rates trajectory. While the correlation of yield diffs with currencies is not rock-solid, it’s certainly an important factor. Differentials may even become the “Main Event” again. Oxford Economics finds that 50% of those it surveys expect a recession in Europe in the next 12 months. If that sufficient reason to put off fighting inflation? This reminds us to reconsider our forecasting timeframes. Yes, we trade on the near-term data, but those longer-term forecasts for growth and inflation never seems to include an option in which (1) the Russian war is over and (2) China gets some form of zero-Covid it can live with. Or both. Let’s say those two Events occur by the fall, say Oct 1. We must expect the usual post-war and post-pandemic consumer spending spree everywhere in the world. Inventory hoarders will release supplies. Ports will clear out. There will be dancing in the streets. The West will shower Ukraine with reconstruction money, some of it to be spent in other countries. Not least is the price of oil tanking, on the drop in uncertainty even in the face of higher demand. How about oil back to (say) $60? This is the point at which the Fed and other central banks are going to look brilliant. This is not a forecast! But it is a warning that talk of recession really does need to be moderated by alternative outcomes. We are not seeing that kind of talk anywhere, yet. Note that once the inflation bandwagon gets rolling, it’s very hard to stop. The Fed’s tools are not up to the job, either. Nobody is talking about price controls or new rules against price gouging, but the data we have already indicates inflation is hardly likely to subside back to the 3-4% level next year as just about everybody is forecasting. See the charts from The Daily Shot. Our criticism of the economics profession can be summed up by the one and only economist joke—if you forget your phone number, an economist will be glad to estimate it for you. These days we have Nobel winner Krugman saying recession ain’t necessarily so, while fat-ego ex-TreasSec Summers says a soft-landing is improbable and recession is for sure. Bloomberg notes that in a recent survey, only 27.5% of economists foresee recession. We say this doesn’t pass the “So What?” test. They didn’t foresee the subprime mortgage-backed securities business bringing down the financial system in 2008, either. (Actually, one Fed board member [Fred Miskin] did, and presented a paper at Jackson Hole on that subject, but disgraced himself shortly afterwards and had to depart, so became the boy crying wolf rather than the boy with a finger in the dike. The point: uncertainty is high and when uncertainty is high, Kahneman warns we tend to fall back on old heuristics, meaning rules-of-thumb that might not have worked in the past but seem sensible. They’re not, and are not a substitute for judging risk, either. We say the old ideas about inflation and recession may well turn out to be invalid because of the pandemic and the war. In the last 50 years in which no yield curve inversion was not followed by a recession, we didn’t have a war. And the one inversion that didn’t bring recession was during the height of the pandemic. And that’s on top of our inflation/recession assumptions based on a history that didn’t have quantitative easing to contend with. Maybe it’s true that historically, recessions follow inflation with an average lag of 13-33 months, but none of them followed conditions of QE, war and pandemic. If that lag really something we can count on? And where does the real rate enter the picture? Again, QE has screwed that up and will take more than a year to fix. Since it’s...

The Japanese yen can’t seem to buy a break, as the currency has been pummelled by the US dollar, and is down by a massive 9% this year. Earlier today, USD/JPY hit 126.68, its highest level since May 2002. With the yen in free-fall, the 130 line is looking like a real possibility. Yen at 20-year low The main driver behind the yen’s massive fall is the widening US/Japan rate differential, as the yen is very sensitive to rate moves. US yields did edge lower earlier in the week but quickly recovered, as US 10-year yields have risen to 2.83%, marking a 52-week high. With even Fed doves like Lael Brainard talking about super-size rate increases of 0.50%, there’s a strong likelihood that the Fed will accelerate its tightening cycle, which would provide a strong boost for the US dollar. USD/JPY has breezed past its multi-year high of 125.80 and the upswing looks ready to continue into next week. The Bank of Japan has tried to curb the yen’s nasty slide, trying to “talk down the yen” by stating that the Bank is watching the markets closely and that it is uncomfortable with rapid moves in the exchange rate. That clearly hasn’t done the job, raising the question of whether the central bank will take more aggressive action and intervene in the currency markets. Many major central banks are tightening policy in response to spiralling inflation, but that is one headache the BoJ doesn’t have. Inflation has risen in Japan due to high commodity prices and supply chain disruptions, but CPI still remains under 1%. A weak yen is ‘good for business’ as it makes Japanese exports more attractive, and the BoJ recently stepped in to defend its yield curve control, when JGB’s showed some upswing. The central bank hasn’t shown any signs of intervening to prop up the yen, but it could change its tune if USD/JPY heads towards the 130 line. USD/JPY technical USD/JPY has broken above resistance at 126.15 for the first time since May 2002. Above, there is resistance at 127.63. There is support at 125.23 and 123.74.

Summary United States: Inflation Hits Hard in March This week's U.S. economic data were led by the largest monthly increase in the Consumer Price Index (CPI) since September 2005. The squeeze on households' from skyrocketing prices for necessities is very real and was evident in this week's retail sales data. However, underneath the surface there are signs that pandemic-related inflation is beginning to ease. Next week: Housing Starts (Tue), Existing Home Sales (Wed), Leading Economic Index (Thu) International: U.K. Inflation Soars While Growth Slows Recent economic data from the United Kingdom reflected the global trend of higher inflation and slowing growth. The U.K.'s March CPI data release showed inflation pressures surged even higher last month. Headline CPI Inflation is now at a 30-year high, quickening more than expected to 7% year-over-year. Next week: China GDP (Mon), South Africa CPI (Wed), Eurozone PMIs (Fri) Interest Rate Watch: Foreign Central Banks Shifting into Tightening Mode Not only did the Bank of Canada hike rates by 50 bps this week, but some other foreign central banks have also taken their policy rates higher in recent weeks. We expect that the Federal Reserve will tighten policy more than most other major central banks, with the possible exception of the Bank of Canada, which should continue to support the value of the U.S. dollar against most major foreign currencies. Topic of the Week: Factors to Consider for a Net Zero Carbon Economy If corporations are to achieve net zero greenhouse gas emissions by 2050, there will be many economic impacts. Our recent report contextualizes the current state of greenhouse gas emissions and considers the larger economic implications of a transition to a net zero carbon future. Download the full report

There are two major market events scheduled for today ahead of the long Easter weekend. investors will be keeping an eye on the monetary policy announcement from the European Central Bank at 12:45 pm BST as well as a US retail sales report for March at 1:30 pm BST both of which could be volatility triggers for EURUSD and stock markets. When it comes to the European Central Bank monetary policy decision, nobody expects the level of interest rates to be changed as the ongoing Russia-Ukraine conflict has caused a significant disparity in the approach between the ECB and the FED. However, there is no consensus when it comes to asset purchases since some banks expect the ECB to announce the end of APP by the end of May today and start preparing markets for a potential rate hike as soon as June while others do not expect such an announcement ahead of the June meeting as this will be when the updated set of economic forecasts is released. In either today we could be seeing some significant moves in markets as a result of these events along with some portfolio rebalancing as investors and traders attempt to limit their risk exposure ahead of the long weekend. US earning season continues with major financial institutions After yesterday’s lackluster results from Blackrock and JP Morgan, investors are looking at today's earnings reports from other major financial institutions such as Citigroup, Morgan Stanley and Goldman Sachs for some reassurance. While most expect results for the first quarter of 2022 to be worse than a year ago, any unexpected negative surprises could worsen sentiment even further as the general economic climate of uncertainty and record inflation continues to pressure consumers and producers. On the other hand, upbeat results could further boost the ongoing rebound of stock markets which started the day quite mixed ahead of the long easter weekend and as many also await today’s US unemployment figures along with the retail sales report at 13:30 BST which will be the first report to capture the whole impact of the Russia-Ukraine conflict.

There are no central bank meetings in the coming week but there’s a ton of data releases to spice things up. The show will kick off with China’s GDP numbers, which will reveal the initial damage from the lockdowns. Meanwhile in Europe, traders will scan the latest PMI surveys to estimate the probability of recession, while keeping one eye on the TV debate between Macron and Le Pen.