Here in the United States, the annual inflation rate – as measured by the headline consumer price index (CPI) – reached above 9% in June 2022. At the time, it was the fastest annual inflation rate in nearly 41 years.
Since then, the inflation rate has steadily subsided, coming in slightly north of 3% in November. Significantly better, to be sure…but still an issue.
In the United Kingdom, the story has been largely the same, even if the inflation rates themselves have been different.
In October 2022, CPI in the UK reached a startling 11.1%, its highest point for the current cycle of global inflation. As with the U.S., however, price pressures have trended downward ever since. Last month, UK CPI checked in at a much more modest 3.9%.
As it happens, this latest version of the inflation story has been about more than price pressures, however. It also has been about notorious problems of the world’s central banks both to identify the nature of inflation this time around and then efficiently and effectively wrestle the runaway beast back to earth.
As for missing the correct call on the “nature” of inflation, that refers to the early and often-repeated characterization of inflation by central bankers as “transitory” rather than as “persistent” or “chronic” …which, of course, is what it has turned out to be.
In the nascent stage of the current inflation cycle, when prices were still below the Fed’s 2% target but there were signs it ultimately might prove to be an issue, Chair Jay Powell said – in reference to concerns about pandemic-fueled excess savings and spending – that “it’ll turn out to be a one-time sort of bulge in prices, but it won’t change inflation going forward.”
That was in March 2021…the same month U.S. CPI marched above 2%. Yet it wasn’t until the end of November 2021, after inflation reached above 6%, that Powell said out loud it was “probably a good time to retire” use of the word “transitory.”
To some learned observers, that change came much too late. Not long after Powell’s mea culpa (of sorts), noted economist Mohamed El-Erian declared, “The characterization of inflation as transitory is probably the worst inflation call in the history of the Federal Reserve.”
To be sure, Powell was not the only high-profile central banker to miss the call as to the nature of inflation.
In early November 2021, the Bank of England suggested it was looking past “factors that are likely to be transient” and suggested UK inflation would reach a peak in April 2022. At the time of that statement, UK CPI (as of October 2021) was slightly more than 4%. Again, the peak of the current cycle wasn’t reached until October 2022, when inflation surpassed 11%.
European Central Bank President Christine Lagarde flatly declared, “Inflation is largely transitory” during an address at the International Monetary Fund. At the time, the ECB said it expected inflation in the Eurozone to peak in late 2021 and begin slowing in 2022.
Which we know did not come even close to happening.
But as I suggested earlier, misidentifying the nature of inflation is just one of central bankers’ admitted lapses in this cycle. A related failure was the inability of central banks to successfully forecast not only the onset of current inflation, but to be at all successful in forecasting its severity and path as it has continued to unfold.
These issues were the subject of a recent article in the Financial Times. The piece endeavors to understand what happened and quotes several high-profile central bankers as to not only their thoughts as to what happened, but what – if any – steps they plan to take to help limit the possibility that any similar misreading of the economy at this level ever occurs again.
As part of our discussion this week, we’re going to look at that article as well as at the central-bank monetary-policy misfires, more generally, that have been such an integral part of the inflation story during this cycle. We’re going to do it with an eye to better understanding what may have gone wrong and what central bankers expect to do to help limit the chances that policy misreads such as those we’ve experienced don’t happen again.
And as we close out, we’ll talk about something else: namely, how some might go about configuring portfolios to help limit the degree to which those misreads – current or future – exert an unfortunate impact on holdings.
Let’s dig in.
In late June 2023, the annual ECB (European Central Bank) Forum on Central Banking was held in Sintra, Portugal. At that assembly, the world’s top central bankers met to discuss an inflation contagion seemingly still a long way from being brought under control.
At that time, the “known” core inflation rate (meaning, as of available May 2023 data) in the U.S. was at 5.3%. In the EU, it also was at 5.3%. And in the U.K., core CPI was at a whopping 7.1%.
It was against this backdrop of relentlessly persistent inflation that the global central banking community publicly expressed bewilderment over their inability to successfully track and contain price pressures through its multitude of forecasting models.
In her coverage of the Sintra forum, Eshe Nelson of the New York Times noted:
The conversations in Sintra kept coming back to all the things economists don’t know, and the list was long: Inflation expectations are hard to decipher; energy markets are opaque; the speed that monetary policy affects the economy seems to be slowing; and there’s little guidance on how people and companies will react to large successive economic shocks.
There were measured, if revealing, expressions of frustration from attending central bankers about the failure of their forecast models to be helpful.
“Our understanding of inflation expectations is not a precise one,” Fed Chair Jay Powell said at Sintra. “The longer inflation remains high, the more risk there is that inflation will become entrenched in the economy. So the passage of time is not our friend here.”
At the time of the Sintra conference, the ECB had shifted to a “data-dependent” approach to policymaking, which means it essentially had declared it was forsaking the use of forecasting models in favor of deciding how to proceed almost exclusively on the basis of current data.
In something of an indictment of central banks’ forecasting record, Pierre Wunsch, governor of the National Bank of Belgium and a member of the ECB’s Governing Council, said at the time it shows that “we don’t trust models enough now to base our decision, at least mostly, on the models. And that’s because we have been surprised for a year and a half.”
So, are central banks discarding forecasting altogether?
No. Efforts are being made to improve it…and those efforts appear focused on creating multiple alternative scenarios to analyze considered policy impacts, rather than seeking to improve more traditional forecasting models that produce ranges of probabilities.
ECB President Lagarde: “We Should Have Learned We Can’t Rely on Models”
Referencing the thinking behind that approach, ECB President Christine Lagarde recently told the Financial Times, “What we should have learned is that we cannot just rely only on textbook cases and pure models. We have to think with a broader horizon.”
Among the challenges facing central banks – and complicating their view of the “horizon – has been the breakdown of what have been historical relationships between and among key economic components.
The Financial Times notes, for example, that research published in 2023 found that incorrect assumptions made by the ECB on energy prices were the fundamental reason behind 75% of its inflation forecasting errors in 2021. In response, the ECB has decided to drill down (pun intended) on refining margins and stop assuming that oil and gas prices will move in tandem.
Across the pond, U.S. policymakers found breakdowns in longstanding relationships among factors within the American economy, as well…including that which historically has bound monetary-policy changes and the unemployment rate.
This time around, the Fed’s aggressive rate-hike campaign has not generated a material increase in unemployment (at least so far) as it has previously. That has suggested to officials the possibility that higher unemployment culminating in recession may not be a given result of aggressively fighting inflation.
“Our economy is flexible and dynamic, and subject at times to unpredictable shocks, such as a global financial crisis or a pandemic,” Jerome Powell said at a recent public event. “At those times, forecasters have to think outside the models.”
Along the same lines, Powell noted in September:
Forecasting is very difficult. Forecasters are a humble lot — with much to be humble about.
As Powell implies, central banking may have always been something of an inexact science. But it seems that in an era with growing uncertainties stemming from multiplying sources, central banking may have entered an era in which it is less exact than ever before.
Which means those charged with the responsibility of portfolio oversight have one more reason to prepare those holdings for the potential impacts that can arise from such uncertainties.
So, how might that be done?
Let’s chat about that as we close out this week.
Among the options available to help mitigate the impact of uncertainty on a given portfolio is to include asset classes that have the capacity to strengthen during the very periods of economic uncertainty implied by unreliable central-bank forecasting.
And it appears one such asset class could be precious metals.
To be sure, metals have their advocates as strategic assets that can lower the uncertainty quotient of a given portfolio. In a recent report, CNBC noted that “gold tends to perform well during periods of economic and geopolitical uncertainty due to its status as a reliable store of value.”
It is by no means only select financial media outlets that seem to think so, either. As it happens, central bankers themselves apparently see it that way, as well.
A few months ago, Aerdt Houben, a senior official at the central bank of the Netherlands, admitted during an interview that gold’s reputation as a store of value is “one of the reasons why central banks hold gold.”
According to the World Gold Council’s 2023 Central Bank Gold Reserves Survey, 93% of central bankers say gold’s potential to serve as a “long-term store of value and inflation hedge” is a relevant factor in their decision to include the metal among reserve assets. Additionally, 96% said gold’s capacity to act as an “effective portfolio diversifier is also a relevant factor in owning it.
Indeed, by some measures, gold remains among the least correlated assets available, underscoring its perceived benefit as an “effective portfolio diversifier.”
Some might even see it as suspiciously coincidental that at the same general time they’re “coming clean” and discussing their forecasting lapses, central bankers are stocking up on gold at the fastest rate on record.
Whether there’s an actual connection, of course, is unknown. But what is not unknown are the following: central banks admit their forecasting is highly uncertain, at present…and central banks are stocking up on gold at a phenomenal rate due in no small way (by their own admission) to gold’s reputation as a mitigator of said uncertainty.
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