Geopolitical Shock: Regime Change in Inflation and Monetary Policy

Globalization is under attack on multiple fronts. Two years after the outbreak of the COVID-19 pandemic and amid growing geopolitical unrest, the decades-long disinflationary headwind has reversed. Many MNCs have taken steps to address the disruptions associated with their expansive and hyper-optimized but ultimately fragile global value chains.

These institutions are reorienting their focus to prioritize availability over cost optimization. This process manifests itself in three ways:

  1. Regionalization: bringing supply chains closer to key markets.
  2. Nearshoring: displacement of supply chains to neighboring production centers.
  3. Offshoring: Reverse, in part, the cost-saving offshoring of previous decades.
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Inflation is a key consequence of these changing priorities. Reorganizing distant global manufacturing centers into redundant regional supply chains demands greater capital investment and resource expenditures in everything from logistics to management. These improvements cost money, and ultimately consumers will pay higher prices in exchange for more reliable supply chains.

Moreover, the process of globalization and the increasingly efficient allocation of resources in recent decades depend on the geopolitical stability of the post-Cold War era. The collapse of the Soviet Union and China’s entry into the World Trade Organization (WTO) allowed cost convergence between the previously segmented commodity and labor markets. This created disinflationary pressure in the advanced economies. In retrospect, the Iron Curtain was an important barrier that kept abundant grain harvests and energy resources from developed economies.

However, as cracks develop along geopolitical fault lines, new obstacles could emerge to disrupt global trade. The “peace dividend” of the past 30 years could erode further: blockades, embargoes and conflicts could create costly supply chain diversions.

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An inflation “paradigm shift” constrains monetary policy

Against the backdrop of the Russia-Ukraine conflict and prolonged disruptions related to the pandemic, Agustín Carstens, director general of the Bank for International Settlements (BIS), acknowledged that “the structural factors that have kept inflation low in recent decades may decline as globalization recedes.” .” It continued:

“Looking even further ahead, some of the structural disinflationary winds that have blown so strongly in recent decades may also be waning. In particular, there are signs that globalization may be receding. The pandemic, as well as changes in the geopolitical landscape, have already begun to make companies rethink the risks involved in the expansion of global value chains.And, regardless, the boost to global global supply from the entry of some 1.6 billion workers from the “former Soviet bloc, China and other EMEs in the effective global workforce may not repeat itself on such a significant scale for a long time. If the withdrawal from globalization increases, it could help restore some of the energy companies of prices and workers lost over the past decades.”

Under Carstens’ framework, a paradigm shift in inflation is also a paradigm shift in monetary policy. Major central banks have had significant operational freedom to engage in unconventional monetary easing (money printing) thanks to the disinflationary effects of globalization. The new inflationary pressure could change this dynamic in reverse. Instead of applying quantitative easing (QE) as a response to virtually every downside shock, central banks should calibrate future support to avoid exacerbating price pressures.

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Yield curves monetary policy forecast instead of recession

Despite these changing circumstances, both the European Central Bank (ECB) and the US Federal Reserve maintained interest rate suppression policies well into the rise in supply-driven inflation. The ECB’s monthly bond purchases totaled €52 billion in March 2022 as the eurozone’s harmonized index of consumer prices (HICP) reached 7.5% year-on-year (y-o-y). As the Fed slowed QE flows in February, personal consumer spending (PCE) was already at 6.4% year-on-year. Despite QE’s role in suppressing long-dated bond yields, the ECB’s purchases in 2022 will fall to €40bn in April, €30bn in May and €20bn in June, before stopping “at some point” later.

ECB Asset Purchase Program (APP) and Pandemic Emergency Purchase Program (PEPP)

Chart showing the ECB's Asset Purchase Program (APP) and Pandemic Emergency Purchase Program (PEPP)

QE programs have anchored long-term global interest rates and co-movement between European and US long-term yields. Lael Brainard of the Fed’s Board of Governors acknowledged the ability of foreign QE to lower long-term US bond yields. Thus, expectations of a rise in short-term Fed rates amid ongoing foreign QE contributed to the inversion of the 5s30s US Treasury yield curve.

Vineer Bhansali, CIO of LongTail Alpha and author of The incredible upside down fixed income market, also noted how politics affects the yield curve. Because central banks can influence all points on the curve through QE, the shape of the yield curve reflects the outlook for policy rather than the likelihood of recession. As Bhansali said:

“The first and most important signal that the Fed has distorted is the shape of the yield curve. Yield curve inversions, in particular, are well known to market participants as a reasonably good predictor of recession. Historically, it is i.e. Right now, the Fed has so many Treasuries that it has the power to make the yield curve whatever it wants.

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To add to Bhansali’s framework, an inverted yield curve incorporates the expectation that rate hikes will slow the economy as inflation declines and disruptions are reduced, thereby freeing central banks from policy constraints, a convergence to the “old normal” before 2020, which would reduce the hurdle of renewed QE suppressing long-term yields.

Conversely, an inflation regime shift driven by a more fractured world with scarcity-driven reflation calls for a reversal of balance sheet expansion or quantitative tightening. The Fed’s guidance on how it would unwind its balance sheet, at $95 billion a month, beat the expectations of many bond traders.

Fed balance sheet easing scenarios, pace rather than composition change

Chart showing Fed balance sheet easing scenarios, pace rather than change in composition

Expanding supply chains drive inflation (and politics)

As geopolitical instability disrupts the once efficient allocation of resources, the relative peace and prosperity of the past 30 years is being reassessed. Could the lack of major power rivalries in recent decades be the exception rather than the rule? And if the atmosphere deteriorates further, what will it mean for today’s globalized value chains?

This framework suggests the potential for supply-led inflation rather than disinflation. More unrest could fuel a deglobalization process of regionalization and cutbacks in the supply chain that increases inflation. However, a less expansive supply chain may benefit from re-expansion once disruptions end and inflation falls.

In market terms, current bond yields in developed countries cannot fully compensate investors if markets become further fragmented. Carstens’ theory of an inflation paradigm shift leading to a monetary policy paradigm shift implies significant risks for long-term bonds assuming a worsening geopolitical outlook and further supply chain disruptions.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / Thomas-Soellner

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Victor Xing

Victor Xing is founder and portfolio manager of Kekselias, Inc., and a former fixed income trading analyst at Capital Group Companies with a focus on monetary policy, inflation-linked bonds and interest rate markets.

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