Why are financial markets so complacent? by Anatole Kaletsky

Markets and central banks are confidently anticipating a comfortable new era of “Goldilocks” for the global economy that will see everyone live happily ever after. But investors’ optimistic outlook is based on four cognitive biases.

LONDON – Do you believe in fairy tales? If so, you could probably make a lot of money these days as a financial trader or gain power and prestige as a central banker. With annual inflation in the US, eurozone and UK hitting 40-year highs and likely to hit double digits after the summer, financial markets and central banks appear confident that war against soaring prices will be over by Christmas and interest rates will begin to fall next spring. If that happens, the global economy will soon return to the financially perfect Goldenilocks fairy tale conditions that have fascinated investors for the past decade: neither too hot nor too cold, and still just for profits.

Investor optimism can be seen in the trillions of dollars recently wagered on three closely related market bets. Money markets now expect U.S. interest rates to peak below 3.5% in January 2023, then decline from next April to around 2.5% in early 2024. Bond markets expect the U.S. inflation will plummet from 9.1% today to just 2.8% in December 2023. And stock markets are assuming that the economic downturn driving this unprecedented disinflation will be moderate enough that corporate earnings U.S. businesses grow 9% in 2023 from record highs this year.

Central bankers are more nervous than investors, but they are reassured by their economic models, which are still based on updated versions of the “rational expectations hypothesis” that failed so miserably in the 2008 global financial crisis. These models assume that expectations low inflation are the key to maintaining price stability. Central bankers therefore see “well anchored” inflation expectations as proof that their policies are working.

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