A new economic paradigm or comedy of errors?

Both views of the economy have merit, but neither should be acted on by institutional or individual investors seeking to achieve long-term goals.

After a long slumber, inflation is awake and creating havoc for consumers and financial markets. The drama of the moment is amplified by the starting line from which inflation began its race higher. Since the early 1980s, the global economy mostly experienced a period of disinflation and steadily falling interest rates. Conditions were so benign that economists dubbed the period the “Great Moderation.” It was a nearly perfect setup for financial markets that seemed to gallop inexorably higher.

My, how times have changed. Like a lightning bolt out of the blue, inflation, rising interest rates and generally overheated economic conditions dominate the landscape. The problem is global, so central banks around the world are tightening financial conditions to kill excess demand and eliminate unacceptably high inflation rates. Financial markets are now digesting the prospect of slowing profit growth and rising discount rates. Indeed, the first half of 2022 produced the deepest negative returns across asset classes in decades.

Sources of inflation are usually hard to identify, but recent circumstances might provide an exception. The COVID-19 pandemic led to unprecedented paralysis in the global economy and supply chains (this is one of the rare moments when use of the word “unprecedented” is appropriate). Politicians and central bankers seeking to minimize damage to businesses and households dusted off the playbook used during the financial crisis. This time, limits to policy actions were set aside to offset the effects of a disaster that was unfolding in real-time. An enormous amount of new money was printed and spent to breathe life into the collapsing economy.

 

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