As Britain swelters in record temperatures, even hitherto healthy US banks and miners are starting to struggle through an equally difficult economic climate. They are not alone (see ‘Cost pressures cause jump in profit warnings'), and their grumbles about the worst environment in decades and warnings of tough times ahead illustrate the continuing challenges faced by markets and economies.
There are snippets of good news – UK dividends returning to their high 2018 levels and the risk of recession still in the balance rather than a dead certainty – but stock markets are not back on terra firma yet, and as we move further away from the pandemic, the direction of travel is not back towards the halcyon days of the pre-pandemic era. Instead, we are being ushered into unfamiliar and more volatile territory.
The way back is blocked, for now at least. The pandemic and years of generous quantitative easing support have bequeathed to the global economy a raging inflation problem, while the repercussions of Russia’s war on Ukraine are energy and food security crises. And as the extreme weather this week reminds us, we cannot rule out additional chaos, disruption and losses as a consequence of climate change.
This troubled backdrop has left a question on many lips which is, has the economic landscape changed permanently, or, in other words, has Covid-19 delivered a killer blow to the era of the great moderation, that period of economic stability when, mostly, growth came easily and inflation was ‘just right’?
It’s not the first time the question has been asked. At the time of the global financial crisis, it seemed that this calm macroeconomic backdrop had reached the end of the road, but it hadn’t, thanks largely to the intervention of the central banks, which swiftly began dishing out gallons of monetary medicine to cure the patient.
The answer to the question depends partly on how the great moderation came about. Was it the result of immense good luck and chance events, with policymakers ultimately having little responsibility for creating a temperate climate?
The view of former Federal Reserve chair Ben Bernanke was that a combination of factors was responsible. These were: improvements in monetary policy, structural changes in the economy (such as the transition away from manufacturing towards services, new technology enabling companies to manage and implement strategy far more effectively, and the rise of China), and lots of good luck – the world just got lucky that there were fewer economic shocks from the late 1980s onwards. If he was wrong, and it was all down to the ingredient of luck, said Bernanke, then the variability of output growth and inflation could at some point return to the levels of the 1970s.
If luck is the key, this could mean that corralling economies back to a climate of safety and security, and minimising volatility, may not be within central banks’ power. Yet it is impossible to deny that central banks exert a powerful influence – the evidence is there to see.
But to return to the bigger question of whether the great moderation has come to an end. Although there is a case to be made that the current deteriorating conditions are transient, the opposite argument almost certainly carries greater weight.
Researchers for Barclays’ latest Equity Gilt Study surmise that the macroeconomic environment is changing, with implications for macroeconomic stability. Their view is that, not only was the period of the great moderation “becoming harder and harder to sustain”, but the pandemic has coincided with structural changes that will make it more difficult for monetary policy to achieve stable policy outcomes over the coming decade.
They point to the strengthening of workers’ bargaining power due to onshoring and labour shortages, the onset of less predictable supply conditions, and the unleashing of new economic shocks as factors that have diminished the flexibility of central banks and increased the risk that policy changes will add to volatility rather than reduce it.
Their conclusion is that we face greater volatility and instability in the years ahead and that the UK (as a result of Brexit) faces more headwinds than anyone else.
That is something investors need to allow for: a greater incidence of economic shocks, and, for all their bold words on reeling inflation back in to a 2 per cent target, seeing central banks forced to adapt to a higher, and more unsettling, target rate.
