The writer is co-chief investment officer for Bridgewater Associates
As economies continue their transition from an adrenaline-fuelled lift-off to more self-sustaining growth, policymakers will increasingly be confronted with choices as challenging as any since the 1970s.
The monetary and fiscal stimulation that was applied during the pandemic and earlier in the US and most developed economies boosted incomes, filled wealth gaps and raised household wealth.
Importantly, the spending that resulted from this is measured in nominal terms before taking into account inflation. That is connected to the nominal flow of credit that initially came from the expansion of government credit, financed by printing money. How that nominal spending divides between real gross domestic product and inflation depends on the quantity produced.
To date, production cannot meet this high level of nominal demand or expand quickly enough. As a result, the very high level of nominal spending is producing a lot of inflation, which is seeping into the cost of living and wages and the need for pay to keep up.
In other words, a self-reinforcing inflation cycle is building. We are now facing the greatest potential for a sustained rise in inflation in decades.
These conditions will require a policy transition. It is clear that policymakers now realise this, but it is not clear how aggressive their moves will be. Given the circumstances, odds favour them moving too little and too slowly.
The pandemic and near-zero interest rates make their choices especially difficult. With Covid-19 and the risk of new variants constantly in the background, there will be continued questions about whether rising inflationary pressures will persist as well as ongoing uncertainty about the effects of the pandemic on economic growth.
These questions will be compounded by the asymmetric ability of central banks to tighten versus ease. Policymakers have a full arsenal of policies to tighten. But with nominal rates near secular lows and asset prices high, they have only one form of policy to stimulate — money printing co-ordinated with fiscal expansion.
That lever is now less available because rising inflation is causing political resistance to further action. And with the politics of government spending now increasingly fraught, if the US Federal Reserve overtightens, it may even do so into a time of fiscal drag instead of stimulus.
Finally, the Fed will be worried about the sensitivity of the economy to rising rates after it was forced to quickly reverse course after the 2018 tightening. Taken together, this set of circumstances incentivises the Fed to stay looser for longer on monetary policy, which leaves room for a more entrenched inflation cycle.
While the Fed and other central banks are probably concerned about heightened sensitivity to tightening, there is a reasonable probability that the economy may actually be less sensitive to a rise in interest rates than recent experience would suggest.
The improvement in household balance sheets, particularly those of the middle class, implies a greater degree of resilience to monetary tightening. And given the rise in inflation, there is more room to raise nominal rates without tightening conditions in real terms.
Carrying this set of conditions forward, a diminished economic sensitivity to a rise in interest rates combined with a cautious approach to raising them would add further to the risk of falling behind the curve, followed by a more significant tightening with an even bigger impact on economies and markets at that time.
So how much and how fast should they move? Given current low unemployment, to achieve target inflation levels, the tightening must slow nominal demand growth to a level moderately above the growth of the labour force plus productivity.
Doing that will require a combination of draining reserves held by banks at the Fed and a rise in real interest rates. It will also require higher interest rates relative to what is discounted by the market and an increase in short-term bond yields relative to long-term ones. This process is, of course, a dance in relation to unfolding conditions, but these would be important criteria.
For investors, these circumstances create two unique risks relative to the past four decades. First, there is the risk that asset values will fall in real terms due to a sustained rise in inflation. Second, there is the risk of central banks falling further behind the move in inflation and having to aggressively catch up.
In the very near term, continued loose monetary policy would tend to have benign effects along the lines of a mid-cycle economic transition. However, too much delay could mean the stimulus is overextended. The longer-term risk is the Fed falling behind in tightening and then forced catch-up with a much bigger response.