Excess savings – in other words, the accumulated savings above pre-pandemic trends – amount to around 10% of gross domestic product (GDP) and 15% of disposable income in the US, and to around 6–7% of GDP and 10% of disposable income in the euro area and the UK.  Some of these savings are bound to flow back into the economy as reopening leads to renewed growth in consumption and investment.

A recent survey in the UK reported that 27% of respondents planned to spend their savings on consumer goods and services, with a further 10% planning to spend on home improvements. There have been similar findings in the US and Europe.

How much will be spent – and how fast – remain difficult questions to answer, although a 20% reduction of the excess savings over a period of 2–3 years seems to be a realistic scenario across the G3 regions (UK, US, and Euro Area). In addition to a normalisation of the propensity to spend, this should provide an extra boost to consumption of between 6–8 percentage points between now and the end of 2023, according to our estimates.

All of this reduces the likelihood of the economy being faced with a ‘fiscal cliff’ – the withdrawal of fiscal support at a time when economies haven’t fully recovered from the pandemic. There are fears that such a fiscal cliff could cause an abrupt slowdown in growth from 2022 onwards, but we believe these are exaggerated.

Instead, we think it’s more appropriate to view fiscal policy tightening measures alongside the build-up of savings during the pandemic. These excess savings in part reflect previous fiscal stimulus measures, and the normalisation that we expect in the coming years should be seen as the delayed deployment of part of the pandemic fiscal stimulus. So, that fiscal boost will in reality continue to be felt for many years to come.

But the downside is that increased spending could also lead to more inflationary pressures building up, especially at a time of supply-side constraints. What might that mean for major central banks’ reaction functions and, in turn, financial assets? Let’s take a look.

The Bank of England’s (BoE) approach has been clear throughout the pandemic. Shaped by the experience of the Global Financial Crisis, the Monetary Policy Committee opted to ‘go big and go fast’, in the words of Governor Andrew Bailey: slashing the Bank Rate to 0.10%, doubling quantitative easing (QE) purchases to £895 billion, and reviving lending support mechanisms (including substantial loan guarantees).

Yet as the UK economy emerges from lockdown, the Bank’s proclivity for accommodative policy has waned. The proximate trigger for this hawkish shift is inflation overshooting. But while its near-term signalling is unambiguously hawkish, its underlying reaction function remains much more uncertain.

The problem is that the Bank’s near-term policy shift has not been accompanied by more clarity about how far it is prepared to go. This increases uncertainty about its medium-term policy, and also raises the risk of either a policy error or a materially weaker domestic economy.

What does this mean for markets?

There are tentative signs of ‘policy error’ risk, with three-month LIBOR futures on an upwards trajectory until autumn 2023, at which point rates then dip by around 10 basis points over the following year. For risk assets, much depends on how far the BoE is willing to go in tightening and how damaging that is to the economic outlook. Given the trends seen in the US and Europe (more on this below), a more aggressive BoE suggests there could be a period of relative outperformance for UK assets. And while the extent of that outperformance is unclear, it’s reasonable to expect higher levels of market volatility in the UK in 2022 as well.

As long as inflation expectations stayed anchored, we expect the Fed to be “relatively” patient—by holding off on rate hikes until Q4 2022—versus the earlier start priced in by markets. However, given continued disrupted supply chains and labour market shortages, officials understandably seem a little more uncertain about the inflation outlook.

In 2022, we don’t believe the Fed will be willing to tolerate too persistent of an inflation overshoot, and expect officials will need to fine-tune their communication (i.e., putting more emphasis on the importance of retaining price stability) and look for a gradual rise in rates.  

What does this mean for markets?

If inflation remains limited, volatility should remain low, risk assets supported, the US dollar relatively weak, and rates relatively contained, with a modest number of hikes priced in for 2023. However, markets will respond very differently if inflation – and in turn inflation expectations – rise to the point where the market thinks that the Fed is behind the curve. In fact, this is our baseline scenario for late 2022 and into 2023: with core inflation expected to bottom out around 2.6% in 2022, the Fed risks being forced to raise rates more aggressively to catch up.

All other things being equal, this should result in a stronger dollar. For rates, it could mean a steeper curve if accompanied by an inflation rate that fails to fall back toward the Fed’s 2% target. Alternatively, though, it may imply a flatter curve if and when the Fed begins to hike aggressively. Overall, we are likely to see higher rates in either case – and more volatility for risk assets.

The European Central Bank (ECB) culminated a decade-long dovish shift with its Strategy Review in July 2021. Although well known to ECB watchers by now, the main changes for the monetary policy approach are worth repeating:

• A new target inflation rate of 2% (year-on-year rate)
• The promise of a symmetrical response around that target
• Particular attention is being paid to the existence of a lower bound for policy rates, for the first time explicitly recognised as a major constraint to policy
• Assessment of financial conditions is now of fundamental importance.

Inflation is now rising quickly – which hasn’t been lost on Europe’s central bankers. But it’s equally clear that the ‘transitory’ narrative (that these spikes will be short-lived) is still dominant. Most professional forecasts (the ECB’s included) see inflation falling again and taking a long time to get back to target. Policy rates are likely to stay low for a long time to come – most likely until well into 2023 at least.

What does this mean for markets?

If higher inflation does establish itself, a stronger euro looks likely as QE slows. Yields at the short end of the curve would probably rise more slowly than markets currently expect. Significantly higher rates will be slow to come, both as the ECB tries to re-anchor inflation expectations somewhat higher, and because the natural rate of interest is low. Until then, yield curves are likely to remain relatively steep.

Asset purchases and low rates will continue to support sovereign spreads and risk assets, even if the ECB does eventually exit its low-rate policy.

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