Friday Highlight  

Inflation: Back to the future?

Inflation: Back to the future?

For the first time in a generation, inflation is rapidly becoming the number one concern among investors.

Signs of inflation are growing more obvious, from soaring shipping costs; rising energy, food and general commodity costs; to shortages of products and labour.

The Citi Global Inflation Surprise Index, which measures actual inflation against economists’ forecasts, is at its highest since the series began in the late 1990s.

The cost-of-living crisis makes disturbing headlines, but talk of stagflation is probably too extreme. With the global vaccination programme breaking the link between Covid cases and hospitalisation, there is still potential for a rebound to more normal levels of services activities.

This could be fuelled by large amounts of excess savings of 5 to 10 per cent of GDP, accrued by households across most developed economies during the pandemic, and should sustain a decent level of global growth in 2022.

However, growth may be associated with uncomfortably high inflation and force central banks rapidly to reverse the extraordinary amount of monetary support provided during the pandemic.

This outcome is not yet priced into financial markets and could lead to a derating of asset prices, which are being propped up by today’s low, long-term interest rates.

The greatest focus is on US inflation, as the US dominates the structure of global interest rates: if the US Treasury market comes under pressure, it will drag up interest rates around the world.

Inflation is currently well above the Federal Reserve target, with core consumer price index at 4 per cent in September and expected to rise further into early next year.

The view from the Fed

For months, Fed chair Jerome Powell has been arguing that this increase is largely transitory, and that economic slack would mean inflation should quickly ebb away.

Initially, this argument was well supported by the data: price increases were narrowly focused and linked to the reopening of the economy, experiencing a ‘one-off’ recovery from their lockdown troughs.

Isolated supply-chain disruptions, such as in semiconductors, also led to some erratic price gains, most notably the 40 per cent surge in used car prices.

But the Fed narrative could be about to shift as price pressures are broadening across goods, rents, recreation services and restaurants. This has been reflected in an acceleration in the median CPI over the past couple of months, even though the monthly readings on overall core CPI appear softer than earlier in the year.

The Fed probably expects the pressure on freight rates to decrease sharply in 2022. There does not appear to be a shortage of ships, but they have ended up in the wrong place and have been unable to offload their cargo.

Goods demand has been unusually strong, as consumers shifted expenditure away from ‘close-contact services’.

Substantial, relative price shifts should encourage movement of resources to alleviate these bottlenecks, and demand should rotate back to services as reopening continues.