World capital markets tumble in wake of rising inflation

On 8 February, the Bank of England issued a statement that was seen by many as a warning for earlier and speedier than previously anticipated increases in the UK base rate. Mark Carney, the governor of the Bank of England, referred in his statement to ‘recent forecasts’ which make it more likely that ‘monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November report’.

A similar picture emerges on the other side of the Atlantic. With labour markets continuing to deliver spectacularly high rates of employment (the highest in the last 17 years), there are also now signs that wages are on an upward trajectory. According to a recent report from the US Bureau of Labor Statistics, US wage growth has been stronger than expected, with average hourly earnings rising by 2.9 percent – the strongest growth since 2009.

These statements have coincided with a week of sharp corrections and turbulence in the world’s largest capital markets, as investors become increasingly conscious of the threat of rising inflation – and the possibility of tighter monetary policy.

The Dow Jones plunged from an all-time high of 26,186 points on 1 February to 23,860 a week later – losing more than 10 per cent of its value in just five trading sessions (suffering a 4.62 percentag fall on 5 February alone – the worst one-day point fall since 2011). European and Asian markets followed suit, with the FTSE-100, DAX and NIKKEI all suffering heavy losses in excess of 5 per cent over the same period.

But why should higher inflationary expectations fuel a sell-off in global capital markets? After all, what firm wouldn’t like to sell its commodities at a higher price? Well, that’s not entirely true. Investors know that further increases in inflation are likely to be met by central banks hiking interest rates. This is because central banks are unlikely to be willing or able to allow inflation rates to rise much above their target levels.

The Bank of England, for instance, sets itself an inflation target of 2%. The actual ongoing rate of inflation reported in the latest quarterly Inflation Report is 3% (50 per cent higher than the target rate).

Any increase in interest rates is likely to have a direct impact on both the demand and the supply side of the economy.

Consumers (the demand side) would see their cost of borrowing increase. This could put pressure on households that have accumulated large amounts of debt since the beginning of the recession and could result in lower consumer spending.

Firms (the supply side) are just as likely to suffer higher borrowing costs, but also higher operational costs due to rising wages – both of which could put pressure on profit margins.

It now seems more likely that we are coming towards the end of the post-2008 era – a period that saw the cost of money being driven down to unprecedentedly low rates as the world’s largest economies dealt with the aftermath of the Great Recession.

For some, this is not all bad news – as it takes us a step closer towards a more historically ‘normal’ equilibrium. It remains to be seen how smooth such a transition will be and to what extent the high-leveraged world economy will manage to keep its current pace, despite the increasingly hawkish stance in monetary policy by the world’s biggest central banks.

Articles

Global Markets Shed $5.2 Trillion During the Dow’s Stock Market Correction Fortune, Lucinda Shen (9/2/18)
Bank of England warns of larger rises in interest rates Financial Times, Chris Giles and Gemma Tetlow (8/2/18)
Stocks are now in a correction — here’s what that means Business Insider, Andy Kiersz (8/2/18)
US economy adds 200,000 jobs in January and wages rise at fastest pace since recession Business Insider, Akin Oyedele (2/2/18)

Video

Dow plunges 1,175 – worst point decline in history CNN Money, Matt Egan (5/2/18)

Questions

  1. Using supply and demand diagrams, explain the likely effect of an increase in interest rates to equilibrium prices and output. Is it good news for investors and how do you expect them to react to such hikes? What other factors are likely to influence the direction of the effect?
  2. Do you believe that the current ultra-low interest rates could stay with us for much longer? Explain your reasoning.
  3. What is likely to happen to the exchange rate of the pound against the US dollar, if the Bank of England increases interest rates first?
  4. Why do stock markets often ‘overshoot’ in responding to expected changes in interest rates or other economic variables