Over the past two years, inflation has been full of surprises. Central bankers are now facing up to the very real possibility that bringing sticky inflation down to their 2% targets could bring deep economic pain. Some analysts are starting to ask whether they might be tempted to tolerate higher inflation instead. 
On this week’s podcast, hosts Alice Fulwood, Tom Lee-Devlin and Mike Bird ask what would happen if ballooning price rises aren’t brought back down to target. The Economist’s Josh Roberts tells them why higher inflation may be here to stay. And Ed Cole, from asset manager Man Group, and Andrew Balls, from PIMCO, explain what would happen in equities and bond markets if it does. 
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This is Michel Ferdinand, it's 1 of our house champagnes.

On this particular bottle we are going to be on a Brut Nature Reserve, so Brut Nature meaning you have 0 percent of sugar in it.

I'm Remy, Remy Furey, I'm the general manager at Champagne & Fromage Covent Garden.

We sell cheese from goat's cheese to cow's cheese.

We are exclusively French so all of our cheeses are French and we try to make an experience to the customer to pair our cheeses with champagne so every champagne will have a different cheese that it goes better with or not.

For 2 years price rises around the world have been rampant and that is being felt across the economy.

2 reasons, they've got a slight increase from our producers.

So we source directly all of our products directly in France.

In France, Agriculture is not thriving at the moment, so they are bound to bring up their prices a little bit.

And on the other hand, what's really developing that price increase in hospitality in general, not only us, is the fact that our bills are going out the roof.

We have to sustain a business at the end of the day."

Central banks have acted aggressively to try and slow down rising prices across the economy.

Let's get more now on our top story, the US Federal Reserve raising interest rates from 5 to 5.25%.

The Bank of England has raised interest rates for the 13th time in a row to 5%.

Interest rate increases are supposed to take the fizz out of the economy, curbing demand to bring rising prices or inflation back under control.

But those rate increases have not proven entirely successful yet.

Demographics and the climate transition might mean inflation keeps jumping.

More rate rises could come with nasty consequences for unemployment and for growth.

So what if central banks decide to let inflation run hot?

You're listening to Money Talks from The Economist, our weekly podcast on the markets, the economy and the world of business.

And in today's show, how the world would change if sticky inflation sticks around.

First, we'll hear why that may be more likely this time.

So the argument is that the inflation we've seen over the last couple of years wasn't just a single lurch, but instead the start of a much longer period of rising prices.

Then we'll hear what impact that would have on financial markets, including the stock market.

Most of us have not lived through inflation regimes.

And finally, how long-term higher inflation would hit the bond market.

That would be very interesting, very disruptive.

So Mike, you're only just barely in Singapore, right?

Yeah, as of the time of this recording, I think I landed in Singapore about 34 minutes ago, which shows the benefits of living relatively close to the airport.

Not that anyone in Singapore lives that far from the airport.

Also shows your commitment and dedication to making it to our Money Talks recording.

So thank you for your mad dash from the gate.

So we are talking about inflation today, which is 1 of those topics we have to keep coming back to.

When prices started rising in 2021, there was a lot of discussion about whether inflation was going to be transitory or persistent, and it has persisted.

So now we are increasingly hearing people debate whether higher inflation is structural in some way, something we're going to have to keep dealing with, or whether it's a cyclical post-pandemic phenomenon.

So I think I've admitted on a previous episode I've done a sort of my mea culpa on being blindsided by the rise in inflation.

I think there's something to sort of coming of age and learning about finance and economics between 2008 and now that made the idea of the resumptions of inflation really hard to believe.

No shortage of people said it a number of times between 2008 and 2020.

It was very difficult to believe then it didn't happen.

I suppose I'm still mostly on team transitory if I'm still allowed to say that, but I am understandably quite a lot less convinced of that than I used to be.

I mean, I do think it's amazing how quickly the consensus on this shifted.

You know, when inflation first started a couple of years ago, many prominent economists very confidently asserted that all this would pass quickly and that inflation expectations were well anchored and then gradually that consensus eroded.

And now I think we're at a position where most people seem to be of the view that inflation is probably not going to come down to, certainly its pre-pandemic levels, anytime soon.

And I think the big question mark is where exactly it's going to land.

And the natural question that follows from that is sort of, so have central banks already done enough to get it back down or is it not quite working, essentially?

You know, they've been raising interest rates aggressively for more than a year now.

You know, in most developed countries, interest rates are at their highest levels in more than a decade, in some places, several decades.

And the interesting scenario to think about is, OK, what if they've not done enough yet?

What if inflation stays high or it keeps coming back.

And you are starting more and more people questioning whether central banks will be willing to keep going, to keep raising interest rates if they haven't already done enough and inflict more pain on their economies to hit that 2% target for inflation.

Yeah, it's going to be really interesting to see if central banks have the metal to create the unemployment and potentially the recessions needed to push inflation down back to the levels that their targets sort of set at.

Well, someone who has been thinking about this a lot recently is the economist Josh Roberts, and I want to bring him in here.

So first up, we just put sticky inflation on the cover of The Economist.

Can you walk us through what the arguments are that we're making that inflation might persist at uncomfortably high levels.

So I suppose the most obvious 1 is that they already have been for quite a while.

So American inflation has now been above its 2% target for nearly 2 and a half years And prices aren't rising as quickly as they were last year.

So then inflation hit 9.1% in the US, 10.6% in the euro area, and 10.4% around the world.

and it's been stuck there for the last couple of months.

American core prices, those are the ones that exclude volatile food and energy, are 5.3% higher than a year ago and that's barely fallen for 6 months.

Now that's what we've seen so far, but there's also a series of big global trends which we might expect to keep pushing prices up in the future.

Populations are ageing, especially in a lot of the rich world.

That'll shrink workforces and it could lead to labour shortages.

After the pandemic and the war in Ukraine, firms are replacing efficient global supply chains with more secure but also more expensive local ones.

And governments are spending more on all sorts of things, defence, supporting those ageing populations and the investment needed to cut greenhouse gas emissions.

Right, but if you look at what the markets are expecting, most investors actually seem to be predicting that inflation will return to its 2% target rate in most developed economies by the end of next year or maybe early 2025.

So do you think they've just got it wrong?

So it's not just me on my own worrying about this.

It's the House view at BlackRock, which is the world's biggest asset manager.

They think inflation will stay persistently higher than central banks 2% targets.

I recently sat down with Jean Boivin who runs their research institute and he thinks that it will settle at around 3-4%.

Richard Clarida who is the vice chair of the Federal Reserve from 2018 to 2022, he's written that the Fed is more likely to reach 2 point something than 2.0.

And when I asked him what something means, he said it could be 2.8% or

And just this week, the Bank of International Settlements, which is often called the central bank for Central Banks, warned that once inflation psychology sets in, it's hard to dislodge.

And though inflation has fallen in the last year in most countries, it's the last mile of bringing it down that's the hardest.

What they're all talking about is that once high inflation takes hold, as it did last year, it's a long, difficult slog to get it back down to central banks' targets.

It's not at all certain that they'll get there at all.

So it's worth considering what long-term inflation of 3 to 4% would mean, and even those couple of percentage points would make a really big difference.

What will happen to financial markets if you and all of these other people that are worried about inflation remaining elevated are correct?

The big headline is that inflation redistributes wealth.

So prices rise in general but not all of them are affected equally.

In the real economy, that might mean your wages don't rise as much as your grocery bill does, so you feel less well off.

In the financial world, what we're talking about is a relative repricing of different asset classes.

Okay, and we are going to go much deeper on all of the implications for equities and bonds with both of our guests in a couple of minutes.

But can you give us just like the 30, 000 foot view of what it will mean for those major asset classes?

So it's not necessarily too bad for equities.

They are ultimately claims on companies' earnings.

And if prices are rising across the board, those earnings ought to be rising too, although that doesn't mean that there won't be individual losers.

Short-term ones might fare reasonably well because if central bankers decide to tolerate above-target inflation, they won't have to raise rates as much in the short term.

Now, raising rates makes bond prices go down.

So if they're not raised as much, that's good for short-term bonds.

Long-term bonds, they would fare worse, because sustained inflation would eat away at the real value of their principal much more.

And also the added uncertainty about how central bankers might cope with higher inflation in the long run would drive their prices down.

1 exception to that might be inflation-linked bonds.

These are sometimes called TIPS in the US or linkers in other places.

So these are bonds where the principal repayment is actually itself linked to inflation, which means it's protected from inflation.

In theory, those don't have the value of their repayment eaten away by inflation.

In practice, though, again, they can be hurt by periods of high inflation.

So, last year, for example, because of the uncertainty in what central banks would do next to cope with the inflationary burst, even inflation-linked treasuries suffered quite big losses.

And we'll move on to our guests now, but I'll ask you to come back at the end of the show.

So, to understand how higher inflation would affect the first of those asset classes, equities, I spoke to Ed Cole, who's a Managing Director at Mangroup, an asset manager.

If we move into a world where inflation is much harder to keep under control than it has been in the past.

What does that mean for the equity market?

So it's terrifically challenging, to be honest.

You have to go back really to 50 years for the last inflationary regime.

And it's tempting to look at the 70s and assume that's the right template, but things will always be different.

My colleagues actually wrote probably what so far has been the definitive paper on this, and they looked at nearly 100 years of inflation data in the US and financial market data to see what asset classes, what types of investment strategies do well in inflationary periods.

Unsurprisingly, they're often the source of inflation, so it's not surprising that they should do well.

The other thing that does consistently well is traditional trend following, which is a systematic quantitative investment strategy, which is in essence a multi-asset.

So you point the models at all sorts of different asset classes, and they identify what is trending, and they follow those trends.

I guess the reason that works so well is because inflationary regimes are disruptive, they change trends and they then trend themselves.

Inflation is not, as we know now today, sitting here 2 years into this, it doesn't end with a bang, it tends to trend and it gets sticky.

The really interesting thing for equity markets is that you have these 2 countervailing forces that are going on.

And we've seen those play out just in the last 2 years.

The first is that assuming that interest rates go up with inflation, which is normally what happens and I think is our experience in most developed economies, higher interest rates, all things equal are quite bad for the way that equities are valued.

And the reason for that is that equity valuation reflects the value today of all of the earnings and cash flows in the future.

And when you raise the interest rate, it's called a discount rate, you penalize those future cash flows more aggressively.

And so if interest rates are going up, then the value today of what you expect to get in the future goes down.

The NASDAQ, which has been the kind of most in vogue market, went from a price earnings multiple, so the price of the NASDAQ divided by the earnings of the NASDAQ of 28, which is a lot, down to 19, which is still quite a lot.

That was the most negatively impacted major market in the world in terms of valuation.

All things equal, If we're in a higher interest rate and inflation regime, we should expect equities to have a lower valuation attached to it.

Against that, you've got the fact that companies earn in nominal terms.

What I mean by that is that they receive price, right?

You go to the supermarket, prices are up.

So if prices are higher, then there are many companies in the world that will be able to, at least in their revenue line, will be able to benefit from that.

And so you've got on the 1 hand the headwind factor of a problem with valuation, on the other hand you've got some sectors and industries that could really benefit from higher inflation.

The most obvious 1 of course is energy markets or energy companies as the price of oil goes up they do much better.

And that push and pull is the complex thing.

Okay, so that's the sort of broad impact on equity markets.

Is there any difference in how this might affect different regions or different countries?

So if you bear in mind what I said about the impact of higher interest rates on the value of cash flows in the future, that has really profound regional implications.

So the US equity market is really what we think of as the long duration equity market par excellence.

So what I mean by that is that it's got the highest concentration of businesses that are kind of growthy businesses that have assets on their balance sheet that are close to perpetual.

And I'm going to give you an example because It sounds a bit hard to get your head around.

Think about the kind of big software businesses that we all know that might have invented software that sits on your home PC that was invented in the 1970s or 1980s.

The earnings and the cash flows that come off that asset have been churned out for 40 or 50 years.

The US is an incredibly innovative economy.

In the last 20 years, that's been particularly entrepreneurs in the technology space and the software space.

So the equity markets there have a very high concentration of these types of businesses, which have got these cash flows that stretch out far into the future based on intangible assets.

Now, that's why this is the most expensive equity market in the world, because the last 15 years where interest rates have been going down all the time has been a phenomenal environment for the valuation of those companies.

course, we are now in a world where interest rates are going up quickly.

You flip it on its head, if we're in a higher and more volatile interest rate regime, the valuation of those businesses starts to get threatened much more.

The flip side of that is short duration assets.

So the long 1 is a software business, the short duration 1 is a company that makes things.

So let's say a company that makes ball bearings, right?

Ball bearing making machine is a really predictable thing.

You buy it, you know it's going to last you 10 years, you know the cash flow that comes from that machine is finite, and that's a short duration asset and a short duration cash flow.

And when you change the interest rate on that, it moves the value around way less than it does on a long 1.

So the short duration market in the world is Japan.

Corporate Japan makes ships and concrete and steel and tech hardware and all those sorts of things.

Corporate America makes immaterial things.

I don't mean they don't mean anything, but you know what I mean, they're intangible.

And what's happened in the last 15 years is that the concentration of capital in institutional portfolios and household portfolios has gone up inexorably.

Venture capital, private equity, public equity, all of it's kind of found its way into the US because it's been just the best story in town.

So if it's higher and more volatile, I think we're going to find that over time people are trying to find ways to defend themselves against the risk that valuations come down, look for cheaper things in essence, and to try to find exposure to shorter duration cash flows which are a bit less volatile and a bit less vulnerable.

Tom, Mike, the thing that I found really interesting from what Ed was saying was how these big macro drivers that we're talking about, inflation and interest rates, are sort of essentially your investing theory of everything.

Here they get into every single trend or analysis of every asset class that you might think to do.

So for instance, if you take the scenario that we're talking about, that inflation remains high, that central banks don't necessarily raise interest rates even more aggressively to head it off.

That gets into how you should think about sectors within certain countries' asset classes, so tech versus everything else.

And then that gets into which countries are the ones you want to be exposed to.

So that is making the case for Japan over the US here.

And it's 1 of those things where your view on what is going to happen with inflation and rates is basically the only opinion you need to have because it essentially informs every other investing decision that you're going to make.

It was a point that Ed made that I thought was really interesting around the impact of interest rates on valuations.

And it is interesting to me how the ratio of corporate valuations to GDP has just ballooned over the past few decades in the low-rate environment that we had up until very recently.

So in 1980, the total market capitalization of America's listed firms was around 40% of GDP and then it began to rise through the 1990s as interest rates came down and now it's around 160% of GDP, which is just a massive increase and far exceeds the rise in corporate profits as a share of GDP that we've also seen over that period.

I also think the question of which companies will win and lose from inflation is a fascinating 1.

So not all firms have the same ability to pass on higher costs in higher prices.

If you're selling quite a commoditized product or something for which there are lots of substitutes, it's actually quite tough.

And then the other factor is around cost structures.

If you're in a very capital-intensive business, whether that's physical or intellectual capital, then your ability to trim costs to improve margins is actually pretty limited.

Yeah, I find Ed's view of this really interesting, and I think that it sounds all sort of very plausible and fits very much with what people are talking about at the moment.

What I then find interesting is how sort of not priced for this markets are.

You look at the valuation of growth stocks, If we talked about, you look at the absolute level of volatility in stock markets, and they're nowhere near being priced for any of this.

If this thesis is right, then there's a huge amount of asset wealth out there that is pretty wildly mispriced at the moment.

And I wonder whether there's an element here, we've talked a little bit about people not really being around during the last inflationary cycle, not that many people who are either investment professionals or just market watchers paying attention to this.

And there still seems to be, if this new world is coming, a more inflationary, semi-permanently higher interest rate environment, then it feels like huge amounts of the market really hasn't adjusted to that in any way.

And there's a huge amount of that still to come.

Well, speaking of surprises, 1 thing that certainly caught me off guard in the past week was the saga around the attempted and then quickly aborted coup in Russia.

We of course have spent a lot of time thinking about that as a paper over the past week and I'm very much looking forward to our coverage on that in the weekly edition.

Listeners can read those pieces and more for absolutely nothing by going to economist.com forward slash podcast offer for a free 30 day digital subscription.

That is if you're not a subscriber already.

After the break, we'll hear how higher inflation for longer would affect the bond market.

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Before the break, we heard how stock markets would react if higher inflation stuck around.

He's Chief Investment Officer for Global Fixed Income at PIMCO.

If inflation doesn't come down and sticks closer to 4% than the 2% target that most central banks had, what would the broad impact be on bonds as an asset class.

If you were to have a shift to expectations of higher sustained inflation, then that would be very interesting, very disruptive.

I mean, it was disruptive enough last year in 2022 with what is going on.

But in terms of the bond market, if that were to happen, you would see a rise in terms of expectations for what central banks are going to do.

So you would be pricing in higher policy rates for central banks.

You may have widening of what you call inflation expectations or break-even inflation priced into bonds.

You could have a repeat of what happened in 2022 in terms of negative returns for bonds, negative returns for equities.

I think, and we at PIMCO more generally, we think it's pretty unlikely that you are going to have a significant shift in inflation expectations towards much higher levels.

There's a number of reasons for this, but 1 of them importantly is we think that the central banks will be committed to getting inflation down towards their targets.

I always think myself that central banks are in effect are inflation expectations targeted.

So formally they're inflation targeters but they're inflation expectation targeters and you can see this in terms of their behavior when you do see instability in terms of inflation expectations rising, you do see central banks react to that.

So you could in the short term get stuck with sticky inflation at higher levels than the central bank targets.

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Money Talks: What happens if inflation sticks?