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Why Are Financial Markets So Complacent?

Markets and central banks confidently expect a comfortable new “Goldilocks” era for the global economy that will allow everyone to live happily ever after. But investors’ sanguine outlook rests on four cognitive biases.

LONDON – Do you believe in fairy tales? If so, you could probably earn good money nowadays as a financial trader or gain power and prestige as a central banker. While annual inflation in the United States, the eurozone, and the United Kingdom has soared to 40-year highs and will probably hit double digits after the summer, financial markets and central banks seem confident that the war against surging prices will be over by Christmas and that interest rates will start falling by next spring. If this happens, the world economy will soon return to the financially perfect conditions of the Goldilocks fairy tale that has entranced investors for the past decade: neither too hot nor too cold, and always just right for profits.

Investors’ optimism can be seen in the trillions of dollars staked recently on three closely related market bets. Money markets are now predicting that US interest rates will peak at below 3.5% in January 2023 and then decline starting from next April to around 2.5% in early 2024. Bond markets are priced for US inflation to collapse from 9.1% today to just 2.8% in December 2023. And equity markets assume that the economic slowdown that causes this unprecedented disinflation will be mild enough for US corporate profits to increase by 9% in 2023 from this year’s record levels.

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 of low inflation are the key to maintaining price stability. Central bankers therefore see “well-anchored” inflation expectations as evidence that their policies are working.

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