Priced for Perfection

Jan 4, 2024

We live in an imperfect world. Yet at the start of 2024, world financial markets were priced for perfection—discounting a complete reversal of the inflationary shock of 2021-22, a modest slowing of the real economy, and prescient central bank easing enabling the economy’s miraculous soft landing. If such a scenario comes to pass, it would make the legendary Goldilocks blush—enjoying a delectable taste of porridge that is neither too hot nor too cold.    

The economist in me grudgingly understands the logic behind this optimistic view. Like most, in 2023 I was too negative on persistent inflation and faltering economic growth and quite concerned that central banks were on the wrong side of history. The biggest mistake I made was to place too much emphasis on inertia, incorrectly believing that a sticky inflation would stay higher for longer, a refrain that also echoed in the halls of the Federal Reserve. I was also convinced that the impacts of the unusually aggressive monetary tightening of 2022-23 would kick in with a lag, resulting in a sharp slowdown of the real economy that might culminate in recession.

Obviously, that outcome didn’t come to pass—either from the standpoint of inflation or growth. The overall headline CPI inflation rate slowed dramatically from 9.1% (year over year) in June 2022 to just 3% in November of last year.  The core inflation rate, which excludes the volatile food and energy components, decelerated a good deal less; it peaked at 6.6% in September 2022 before slowing to 4% by November 2023—a moderation of just 2.6 percentage points, far short of the six-percentage point deceleration in the headline index.  To be sure, based on subdued trends of the past six months, a further slowing in core inflation is possible in the months ahead.

At the same time, the real economy strengthened rather than weakened; the year-over-year increase of real GDP was 3% through the third quarter of 2023, more than 50% faster than the 1.9% gain of 2022. Two explanations are possible—either the time-honored relationship between changes in real interest rates and real economic growth has broken down or the lags of monetary tightening are turning out to be a lot longer than widely believed. While I favor the latter explanation, I concede that the jury is out on that debate.

A year of mea culpas is never a good predictor of the future. Markets priced for perfection presume that what went wrong last year will continue to go wrong in 2024. I fear such a prognosis is wishful thinking.  If there is one thing my fifty years as an economic forecaster has taught me, it is that economics is only one piece of the big market puzzle. Domestic politics, geostrategic tensions, natural disasters, and a host of other non-economic considerations that economists typically dismiss as exogenous factors are equally, if not more, important.

In looking to the year ahead, I have a strong hunch that economic analysis will be of secondary importance in gauging market outcomes. That is especially likely for a conflict-prone world embroiled in two devastating wars (Ukraine and Gaza), to say nothing of acute political angst likely to be evident in advance of the 2024 U.S. presidential elections. Historically, the combination of war and politics often proves most vexing to financial markets, especially when asset pricing is so blasé as it was during the melt-up of late 2023.

Protracted wars are especially worrisome in that they typically play on the weak links of an integrated global economy. They raise the twin possibilities of commodity and supply-chain shocks that would complicate the growth-friendly disinflationary forces that are now widely expected to persist well through 2024. Bottom line: Just as Goldilocks lost her innocence a long time ago, the outlook for inflation, economic growth, and financial markets is likely to be far more disruptive than that currently embedded in the complacency of consensus thinking. Markets priced for perfection are likely to be in for a rude awakening.

You can follow me on X/Twitter @SRoach_econ

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