This week, a combination of events has evoked a recollection of the opening scenes of a popular mini-series from 2019. This recent dramatisation, depicting the events surrounding the explosion, and subsequent fallout from the nuclear reactor at Chernobyl in 1986, has sprung to mind for two main reasons: firstly because of the acute market focus this week on the fallout to the rest of the global economy from Russia and its actions at (and then beyond) the Ukraine border; and secondly, the response of the plant operators in the face of rising temperatures in the reactor core - in this instance a metaphor for global inflation.

Last week, we emphasised our view of the important difference between “rising inflation and falling inflation irrespective of the level at which the peak occurs”; this is perhaps perfectly demonstrated by the Chernobyl analogy. As the core temperature is rising, there is an increasingly urgent need for a response, as the temperature ticks back lower, there is a flood of relief - at least until there is a realisation that the reactor itself has exploded!

For global policymakers, it is likely that the focus becomes increasingly one of growth and not inflation going forward, particularly in light of a renewed, acute, energy shock (an external supply shock) - the last thing policymakers will want to do is explode growth, in the name of defending an inflation trajectory, the core drivers of which monetary policy has little, or no influence over.

Stepping aside from the analogy, there are a number of similarities that central banks are currently facing in light of rising prices, and by extension a rising urgency to react. We saw this as early as March last year in Brazil, as the central bank strove to get ahead of inflation and build a, likely necessary, rate buffer ahead of the Federal Reserve (Fed) normalisation cycle when it came. (We are very much of the opinion that it was this buffer, built up by the Emerging Markets (EM) central banks - in addition to the very modest positioning in EM following the exodus at the early stages of the global Covid crisis - that has provided insulation from a taper tantrum 2.0).

Then, post the renomination of the Fed Chairman in late 2021, the Fed began their hawkish pivot - first with a taper, then an accelerated taper, then gradual rate hike expectations and now a substantive series of rate hikes and a balance sheet unwind starting in March (perhaps with 50bps). Now, the European Central Bank (ECB)has followed with an albeit much more modest pivot of its own. The question that we continue to ask is how quickly and firmly will central banks be able to change the direction of travel for the (temperature of) respective inflation rates, irrespective of the absolute levels - specifically without blowing up growth?

Moving on to the second analogy, we continue to emphasise that the direction of travel for inflation is important, especially if the growth narrative becomes more questionable. In this regard the UK is a fascinating case in point.

The Bank of England (BoE) have been very clear over recent months that the structural shifts in supply dynamics for the UK (post-Covid and post-Brexit) likely mean that there should be an upward shift in the equilibrium rate of interest, thus necessitating higher rates in the near term to defend the credibility of the BoE in upholding their inflation mandate. However, despite the hawkishness of the BoE in recent months - including the fact that four out of the nine Monetary Policy Committee (MPC) members voted for a 50bp hike in February - more recently the narrative has become more dovish. Or at least less hawkish!

Comments such as: the BoE “need to manage the trade-off between inflation and growth” from an external MPC member, that “market rates would push CPI below target within two years” from another MPC member and that “there is a risk that inflation falls quicker than expected … message to markets is not to get carried away” from the BoE Governor, suggesting that the BoE may be becoming less dominated by the inflation narrative and more concerned about the growth dynamic.

Indeed, the Russia situation, and specifically the impact on inflation through an energy price spike, could lead to a moderation of hawkishness from the BoE. Essentially, we are suggesting that there is a convex relationship between inflation and the BoE’s reaction function - especially where the inflation is driven by an external supply shock that monetary policy has no bearing over. In essence, inflation up to a point requires higher rates to restrain demand and moderate inflation, but (and especially if inflation is a function of supply shock) much higher inflation could prove a demand constraint in itself and thus potentially require a smaller monetary response. The BoE have referenced this point on previous occasions suggesting that inflation itself can have a restraining effect on activity and demand.

Furthermore, this external supply shock likely has a restraining impact on the Eurozone in a very similar way, and thus likely significantly damps the recent hawkish pivot from the ECB. In Australia, there may not be the direct feed through into inflation, as energy supply chains are less Russia dependent, but there is clearly a broader global impact on energy prices and dampened consumer demand growth, thus we continue to see market pricing in Australia for 2022 as too keen.

Ultimately, as we discussed last week, we continue to see things boiling down to growth. From a currency perspective, the USD continues to stand out. Excess demand likely means that not only can the Fed hike rates, but with financial conditions still very loose, they can likely do so with modest implications for growth. We continue to see a strong case for normalisation in the US or the need to move off the “emergency stance” as it was referred to by the Atlanta Fed President this week. Markets are currently pricing a move back to approximately pre-Covid levels of monetary policy over the course of this year and modestly higher into 2023.

In the UK, Europe and Australia, markets are pricing significantly tighter monetary settings than were in place before the pandemic struck, with nowhere near the current levels of excess demand growth. From our perspective, that should lead to a differentiation in the currency space as a function of widening yield and growth differentials - favouring the US and the USD.