Legendary World Cup goal shows how modern monetary policy really works
WITH the World Cup now well under way, a football analogy seems fitting.
Perhaps the most pertinent at present would be the one made by Mervyn King, former Bank of England Governor, during a speech in 2005. He likened Diego Maradona’s second goal against England in 1986 to the “power of expectations” when it comes to central bank policy.
Maradona received the ball in his own half and carried it more than 60 yards before tapping it into the net.
What is remarkable is that he glided and feinted past no fewer than five players whilst barely changing direction and virtually running in a straight line.
The crucial point is that this was made possible by the defenders reacting and making decisions based on their expectation of what the Argentinian was going to do – zig-zagging across the pitch and trying to avoid the defenders – rather than what he actually did.
This is just how modern monetary policy really works.
If we consider developments in the global economy and financial markets in 2022, we can see this “Maradona Theory” in effect.
Financial conditions have tightened considerably over the year as markets have been quick to price in higher expected inflation and interest rates, moving sooner and further than the actual rates set by central banks.
There have been very few places to hide for investors in this environment, with bonds and equities moving in tandem and seeing sharp draw-downs during the year.
Not only have interest rates on government bonds moved sharply higher, but credit spreads have also widened to reflect increased risks of an economic slowdown in the economy. The movement in credit costs is of great importance, as this reflects the very real borrowing expenses faced by individuals and businesses in the real economy.
A quick glance at long-term mortgage rates in America and the UK, which have been moving well above base rates in their respective countries, emphasises this point.
These developments have preceded a notable slowdown in the economy, whereby market moves have themselves put the brakes on demand.
While inflation readings have remained stubbornly high, underneath the surface it appears the inflationary pulse of the economy is fading. The previously-mentioned market forces have killed off excess demand following the pandemic, especially in areas of consumer spending and housing. This has allowed the unprecedented global supply chain disruptions created in the wake of the pandemic to ease.
The European energy crisis has also abated as storage levels have been restored faster than expected, in part aided by milder winter weather conditions.
The narrative has shifted from “inflation spiralling out of control” to one of “recession” and now a potential “Fed pivot” in short order.
Students of economic history will note inflationary bear markets tend to bottom out when the US Federal Reserve acknowledges peak inflation by halting interest rate rises or cutting the cost of borrowing. The dramatic year-end relief rally would suggest that this process may have already started, barring any further shocks to the system.
While inflationary pressures might have peaked, it is too early to declare victory just yet. Certain structural factors could well assert themselves after the surge in inflation fades.
Tight labour markets, high commodity prices as we reduce dependence on fossil fuels, the de-globalisation of trade, and a policy mix increasingly weighted towards fiscal measures could all pave the way for “higher for longer” inflation. Inflation may be fading but central banks may need to reconsider their 2 per cent targets.
After 40 years of disinflationary forces, this environment has significant implications for investment markets. The opportunity set for risk assets now appears more attractive across the board, yet we are thinking about the potential for a change of market leadership in the years to come.
If the past is anything to go by, the winners of the last decade are unlikely to be the winners of the next. An actively managed approach will become of increasing importance as companies will have to navigate an environment not seen for decades.
If we consider the economic developments of 2022, we see this ‘Maradona Theory’ in effect