THE world’s top central bankers, led by Federal Reserve chairman Jerome Powell, have warned that rising demand pressures and supply chain bottlenecks are continuing to hold back recovery of the world economy, and have helped to fuel more elevated price pressures as they have intensified.

       It still appears that inflation is running beyond targets even as bottlenecks ease. No doubt, uncertainties still cloud the economic outlook as these factors gather with the more contagious Omicron variant.

       As I see it, what most central bankers really missed was the supply-side constraints – not that, their inflation models were wrong (certainly far from perfect); their radar just missed the scope and persistence of the supply-side constraints.

       Uncertainty lifts volatility, which causes investors to stay away. For them, what the Fed is doing, what’s happening to policy, and what’s happening with the economy – all supports the idea that volatility will be increasing, amid challenging trading conditions over the coming holiday season.

       Psychology around inflation is hard to gauge. Inflation hasn’t been a broad concern since the 1990s, making it trickier to pinpoint consumers’ feelings.

       Psychology is one reason the Fed is likely to signal a faster end to bond-buying and a quicker start to raising interest rates. This is about keeping inflationary expectations well anchored.

       Biden stagflation

       The White House continues to insist that inflation will soon fade away.

       Still, the mounting regulatory burden of US President Joe Biden’s executive orders will stifle growth. All the ingredients are present to turn the current inflation into stagflation. America’s experience with regulatory excess is both recent and painful.

       Gross domestic product (GDP) growth slumped to an 80-year low of 2.1% during the 2010-2016 recovery. The President’s regulatory policy is transforming capitalism. If new spending and monetary accommodation were employed to stimulate sagging growth, that stagnation could easily turn into stagflation.

       Chances are, they will not. It is true that temporary factors have driven up inflation. The March US$1.9 trillion (RM7.7 trillion) fiscal stimulus will not be repeated. During the pandemic, consumers have binged on goods. Supply chains have been bunged up, especially as the world’s factories have faced lockdowns and staff absences. Despite an abnormal number of Americans out of work, firms have struggled to fill vacancies.

       However, the Omicron variant is spreading. For as long as inflation remains high, there is a growing danger that it will become entrenched. Pandemic-related distortions, not excessive demand, have driven up prices.

       There is an unusual surge in demand, not just constrained supply. Tighter monetary policy is therefore justified. But if you believe the Fed’s theory of how its asset purchases work, every bond it buys add fresh stimulus to the economy. It follows that merely tapering the pace of purchases is not really tightening.

       So, why not raise interest rates instead? The answer is that the Fed is bound by its past guidance that it would stop buying bonds before raising rates; and that it would avoid ending purchases abruptly. The good news is that the Fed can taper fast enough to let it raise interest rates in March.

       If between now and then the pandemic worsens, consumers slash their spending on goods or many missing workers return to the labour force, monetary policymakers can change course again. But, in the end, they must give themselves scope to raise rates soon. It is an option that is already be on the table.

       United States

       The Fed has set the stage for a series of interest rate increases beginning in mid-March 2020, reflecting much greater concern about the potential for inflation to stay high. Brisk demand for goods, disrupted supply-chains, temporary shortages, and rebound in travel have pushed 12 month inflation to its highest readings in decades. Core consumer prices (which exclude volatile food and energy categories) were up 4.1% in October from a year earlier.

       The Fed projects core inflation to reach 4.4% at the end of this year, before declining to 2.7% next year and 2.1% by the end of 2024. The Fed expects rates will need to rise next year. After projecting three quarter-percentage-point rate rises next year, most penciled in at least three more increases in 2023 and two more in 2024.

       Questions remain over the tightness in the job market, especially because it is hard to tell how many people might have left the workforce for good. Ending in November, the unemployment rate has fallen by one percentage point, to 4.2%.

       While there are still 3.9 million fewer people working than in February 2020, some of that gap might reflect retirees or others who are choosing not to work, increased household wealth, or lack of child care.

       The Fed now faces two opposite risks. One: they tighten monetary policy that causes the economy to slow on top of a sharp drop in the rate of inflation next year.

       The other: inflation stays higher and households and businesses come to expect prices to keep rising, leading to a wage-price spiral. When the pandemic first hit, it “looked at the beginning like it might cause a global depression. What’s coming out now is really strong growth, really strong demand, high incomes.” What’s to be done?

       A stubbornly higher pace of inflation and much higher interest rates are widely seen as a likely legacy of the enormous stimulus by central banks and governments in response to the pandemic.

       But what if the outcome turns out to be a less impressive recovery, once pandemic stimulus fades leaving a debt hanging like a deadweight on the economy?

       This scenario seems remote given the scale of the rebound in economic activity unfolding at the moment. Actions in the past 15 months have spurred expectations of a sustained global economic recovery, and a decisive shift upwards from the modest expansion that typified the decade before.

       Indeed, this week the Fed upped its forecast from 6.5% to 7% at which the US economy would expand in 2021, and maintained a solid growth rate above 3% for 2022. The US economy failed to match this pace of expansion before the pandemic erupted in the wake of the financial crisis.

       The recognition that strong expectations for the economy will require less monetary medicine beyond this year has stirred financial markets.

       The latest monthly survey of fund managers by the Bank of America noted that investors are “bullishly positioned for permanent growth, transitory inflation and a peaceful Fed taper”. The prospect of a growth scare is very much a contrarian view at this stage of the recovery. But it is one investors should take note of.

       China

       China’s economy is under growing pressure: it now paints a gloomy picture.

       Growth in retail sales slowed to 3.9% year-on-year in November, down from 4.9% in October. Growth in fixed-asset investment was 5.2% for the January-November period, compared with 6.1% for January-October.

       Industrial production accelerated a bit, to 3.8% from 3.5%, although that’s modest growth considering the energy-supply problems that hobbled production earlier in the autumn.

       The official urban unemployment rate rose to 5% from 4.9%. This slowdown has many causes. A big one is the rebalancing: attempting to engineer more balance in its bloated property market. Beijing has tightened credit for developers over the past year, pushing several into distress.

       It’s implausible zero-Covid policy continues to weigh on the economy as officials impose draconian lockdown with no warning whenever cases pop up. Harder to judge are the consequences of mounting official hostility to private companies in growing industries, such as tech. Slowing growth for now could be healthy if it’s the result of a transition to more balanced investment. There are signs of a new round of financial stimulus, since Beijing appears (as of now) to be less willing to risk an extended economic slowdown.

       Beyond China, Covid-related factory closures in Malaysia have hit chip supplies to German car makers in a semiconductor market already hit by outages in Texas, Japan and Taiwan.

       A lockdown in Vietnam has created supply-chain problems for Australian importers. In Indonesia, mining companies want more trucks to feed the world’s rising demand for coal and minerals. Yet the waiting list for new truck deliveries is at least nine months: supply-chain problems make it harder to deliver the fuel and materials that would help resolve supply problems elsewhere, reinforcing the bottlenecks.

       Also, strikes and Covid-19 cases among port workers in Australia have curtailed operations. China has added to the stresses with limits on electricity usage triggered by efforts to address climate change. The northwestern province of Shaanxi is one of the world’s largest producers of magnesium, a relatively low-cost mineral to which electric-vehicle battery makers have increasingly turn-to as demand for electric vehicles rises. The domestic price of magnesium in China was more than 60% higher in August compared with January 2021. The magnesium shortage is one reason among many that may prevent consumers from finding the car they want around the world.

       Japan

       Two tales are often told about Japan. The first is of a nation in decline, with a shrinking and ageing population, sapped of its vitality. The second is of an alluring, hyper-functional, somewhat eccentric society, but of little wider relevance to the outside world. Both tales lead people to dismiss Japan. I think that is a mistake.

       In my view, Japan is not an outlier – it is a harbinger. Many of the challenges it faces already affect other countries, or soon will, including rapid ageing, secular stagnation and the risk of natural disasters. Many Japanese people understand that responding to disasters is everyone’s problem, not just the state’s. Among the G7 countries, Japan has the lowest death rate from Covid-19 and the highest rate of double-vaccination.

       Another lesson is that demography matters. Most societies will ultimately age and shrink like Japan. By 2050, one is six people in the world will be over 65 years old, up from one in 11 in 2019.

       The populations of 55 countries, including China, are projected to decline between now and 2050. Recent data suggest India will shrink sooner than expected. Demographic change brings big economic challenges. Japan owes its sluggish growth in large measure to its shrinking population. In the decade from 2010 to 2019, Japan enjoyed the third-highest average rate of GDP growth per head in the G7, behind only Germany and US.

       Japan is a major creditor and the third-largest economy at current exchange rates. Its people live longer. It is home to the biggest technology investor on the planet, a pioneering 5G firm, and a host of global brands.

       Expertise in robots and sensors will help its firms make money from a wide range of new industrial technologies. Geopolitically, Japan plays a pivotal role between China, its largest trading partner, and US.

       Japan’s mistakes offer another set of lessons. Living with lots of risk makes setting priorities harder. In 2020, it at last pledged to reach net-zero carbon emissions by 2050. Many bureaucrats, meanwhile, remain stubbornly sceptical of renewable energy.

       So Japan keeps burning coal, the filthiest fuel. Politicians tolerate all this in part because they feel little pressure to do otherwise. For the public, today’s comfort dulls the impulse to press for a brighter tomorrow. Japan’s final lesson, in my view, is about the danger of complacency.

       What then are we to do

       Pandemic-driven fears have returned to the fore of investors’ concerns amid surging cases of the Omicron coronavirus variant. Indeed, supply-chain disruptions, labour shortages and rising oil prices have pushed inflation to a 39-year high.

       Traders also shifted into perceived haven assets. The 10-year US government yield fell 0.04% to 1.37%, while the equivalent 10-year German Bund yield fell 0.02% points to minus 0.4%. Meanwhile, US growth prospects were dealt a blow after the President’s flagship “Build Back Better” bill was deemed unlikely to pass in its current form. Following this, Goldman Sachs lowered its US GDP growth forecast for 2022 from 3% to 2% in the first quarter, from 3.5% to 3% in the second, and from 3% to 2.75% in the third.

       China meanwhile eased monetary policy on Dec 20 by cutting its one-year prime lending rate in an attempt to stop the country’s economic growth slowdown from “gaining momentum”.

       It’s the best of times and the worst of times for equities. It’s the worst of times because they have never been this expensive. But they are a bargain relative to buying Treasuries in a 4% inflation environment. That’s why the equity market refuses to go down. Markets need asset classes that give a positive rate of return.

       A recent Bank of America survey revealed that 70% of investors in the study thought this new variant of the pandemic would have little economic impact, thanks to low appetite for lockdowns and the safety net of existing vaccines. Only 5% have identified lingering Covid-19 as the top concern for 2022.

       Instead, it is all about the rates outlook. Inflation has not behaved even remotely like most predicted. Early this year, when US inflation first blasted expectations, fund managers were alarmed but able to shrug off any urge to panic. Since then, efforts to write off inflation as transitory have suffered a collision with reality.

       Central banks have succeeded in being patient, and have declined to rush in with rate rises; But 2022 is widely expected to be the year that they snap. The Bank of England has already nudged up rates, while the Fed has signalled three rises next year.

       The question is whether that is a sufficient response. I am among those who think inflation will calm down, and that the Fed will respond to negative shocks (such as a serious dent from Omicron) by dialling down its hawkishness.

       My view is the Fed will back-off. At most, there will be one Fed hike next year. Its right for central banks to end up being less aggressive. I could be wrong. Inflation might pick up. That’s why we have risk controls. It is a simple wish.

       Former banker, Harvard educated economist and British Chartered Scientist Prof Lin of Sunway University was chairman, Rio International Experts Group on Finance for Sustainable Development, UNCSD, New York, 1994-2004. Feedback is most welcome. The views expressed here are the writer’s own.