Many investors remain cautious, haunted by the high inflation of 2022 and 2023.  However, there are strong reasons to believe that inflation will decline more rapidly than most people expect. 

To understand why inflation is likely to drop, we need to revisit its causes in 2022 and 2023.  The inflation surge of those years wasn’t random; it was an obvious case of monetary inflation driven by over-stimulus and supply chain disruptions.

Governments and central banks responded to the COVID-19 pandemic with unprecedented fiscal and monetary support.  Trillions of dollars in stimulus checks, business aid, and asset purchases were pumped into the economy.  The result?  Too much money chasing too few goods.

Lockdowns and labour shortages caused significant disruptions in supply chains.  Factories slowed production, ports faced backlogs, and companies struggled to meet demand.  This created bottlenecks that pushed up prices.

These forces combined to create a perfect storm of inflation, peaking at levels not seen in decades.

Since 2022, central banks have aggressively shifted gears, aiming to tame inflation.  The Federal Reserve, European Central Bank, and others have tightened monetary policy by raising interest rates and reducing money supply, with quantitative tightening (QT) replacing quantitative easing (QE). Central banks have reduced their balance sheets by allowing bonds to mature without reinvesting.

These actions have led to a prolonged period of monetary contraction.  The money supply is shrinking, which historically has a dampening effect on inflation.  Just as excessive money supply fuelled inflation, its contraction now exerts deflationary pressure.

Inflation tends to be sticky in the short term but responsive to monetary conditions over time.  The conditions that led to the inflation spike of 2022-2023 are no longer present.  Global supply chains have largely recovered.  Ports are moving goods efficiently, and production has normalised in many industries.

Higher interest rates have curbed consumer and business spending, too.  Housing markets have cooled.

Energy costs, a major contributor to inflation in 2022, have moderated.  Oil and gas prices are far below their peak levels, reducing transportation and production costs.

If we look back at the two decades before the pandemic, inflation was consistently low, averaging around 2%.  There’s little reason to believe we can’t return to this range now that the monetary and supply-side imbalances have been addressed.

The Federal Reserve and other central banks have signalled caution in reducing rates, but history suggests they may cut faster than expected. 

The lagged effects of high interest rates are becoming more apparent.  Sectors like housing, manufacturing, and tech are feeling the pinch, and central banks will want to prevent a deeper slowdown.  Governments may also push for lower rates to support job growth and economic expansion.

As inflation metrics fall closer to target levels, central banks will have more room to pivot without risking credibility.  By mid-2025, we could see a series of rate cuts designed to support the economy. Lower rates will make borrowing cheaper and stimulate growth, creating opportunities for investors.

Lower inflation and interest rates are good news for both bonds and stocks. 

The inflation surge of 2022-2023 was driven by unique circumstances: excessive monetary stimulus and supply-side disruptions.  With monetary conditions now tight and supply chains normalised, inflation is likely to return to its pre-pandemic trends.  If central banks pivot to cutting rates, bonds and stocks could see substantial gains.  As always, staying informed and proactive will help you make the most of these market shifts.

By understanding these dynamics, investors can position themselves to benefit from what could be a pivotal year for financial markets.  The key is to anticipate the trends, adapt your portfolio, and stay focused on the long-term opportunities that lie ahead.

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Disclaimer: The views expressed in this article are those of the author at the date of publication and not necessarily those of Dominion Capital Strategies Limited or its related companies. The content of this article is not intended as investment advice and will not be updated after publication. Images, video, quotations from literature and any such material which may be subject to copyright is reproduced in whole or in part in this article on the basis of Fair use as applied to news reporting and journalistic comment on events.

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