Markets Primed To Be Hawkish On Rates

Same high inflation, different drivers

Change in U.S. PCE and euro area inflation, 2022 vs. 2015-19 average

The ECB and the Fed both need to quickly normalize policy from the emergency settings adopted when the pandemic first hit. And they both face inflation that’s running at multi-decade highs – and are feeling pressure to rein it in. The difference: the drivers of inflation. Inflation in the euro area is driven primarily by higher energy and food bills that were exacerbated by the tragic war in Ukraine. See the red and green shaded areas in the bar chart on the right. This should dissipate in the medium term, in our view, as Europe finds new energy and food sources. In the U.S., inflation is more broad-based, with increases driven by goods and energy in almost equal parts (the left bar). We see U.S. inflation as persistent and expect it to settle at higher levels than pre-Covid.

We have entered an era where production constraints have become the dominant drivers of inflation. Think about bottlenecks and difficulties in producing, sourcing, transporting and staffing. Both central banks have yet to acknowledge the sharp trade-off when trying to rein in this type of inflation with rate hikes: Squash growth and jobs or live with higher inflation than before the pandemic. We don’t see a goldilocks outcome where inflation stays near 2% while unemployment remains low and growth resumes an upward trend. This leaves the door open for markets to expect overtightening at any signs of persistent inflation, a tight labor market or economic strength – and keeps us neutral on equities in the short run.