22 Feb 2022
Inflation has surged to 7% in the US and 5% in Europe, and higher prices have now been in the system for a year. With higher readings also seeding higher expectations, is inflation starting to look less transitory?
Headline consumer price inflation rate in the US, UK and Europe
Inflation has moved higher and is proving ‘stickier’ than expected. While some of the short term pandemic-related drivers are abating, there are clear signs of momentum in areas such as housing and wages which are historically more persistent and could keep prices higher for longer than expected. At the same time, our base case still remains that inflation will slowly ease. It’s now central banks’ reaction function that is especially important to the direction of markets, and recent policymaker comments have certainly indicated greater wariness of inflationary threats.
To combat the pandemic, governments and central banks unleashed an extraordinary amount of stimulus, directed both at financial markets and consumers alike. What was originally seen as a demand shock from the pandemic, has manifested itself more recently as a more of a supply shock. Covid-19-related lockdowns and staff shortages created significant distress in supply chains and pushed up manufacturing and production costs. Huge government support payments kept incomes and consumption relatively well supported, while near zero interest rates fuelled a surge in home prices.
Supply-side weakness have certainly been exacerbated by a strong rebound in demand. Surging energy costs, partly due to production/shipping blockages and partly due to growing tensions with Russia, have contributed to a ‘perfect storm’ of supply-related inflationary pain. We expect these supply blockages to eventually dissipate as production continues to come back online. Indeed the most recent US ISM Manufacturing report showed that companies were starting to see production returning and reduced supply chain issues. More concerning for central banks should be the strength in housing-related inflation and quickly accelerating wages stemming from the tighter labour market.
In the absence of external influencers (i.e. a central bank with a specific inflation target) we would expect higher/stickier inflation to squeeze consumer real incomes, should wages fail to keep up with rising price, thereby hurting economic growth. With inflation running far in excess of average wage growth across developed markets, consumers are indeed facing a significant deterioration in their personal finances at present. Moreover, direct-to-consumer government support has now largely finished. Furthermore in some countries we believe governments will look to adopt a more disciplined spending path, which will squeeze consumption even further. Accordingly, we have reduced our forecast for global growth in 2022, however it still remains comfortably above potential.
At present, we feel economies are positioned well to deal with the short-term squeeze via higher prices, which we still believe will begin to recede from here. Labour markets are extremely buoyant and wages are also trending upwards. We can’t rule out a stagflationary environment (high inflation and slow growth) altogether should central banks be unable to re-anchor inflationary expectations and prices. In that scenario, amid some talk of ‘dragflation’, the situation could potentially become more destructive.
The sands are shifting for developed market central banks as the economic narrative has flipped from supporting recovery to genuine concerns of overheating and inflationary pressures. This backdrop has forced a sharp re-think in policy, with significant ramifications for the economic outlook over the next 12 months, and the valuation of all financial assets.
“….the economic narrative has flipped from supporting recovery to genuine concerns of overheating and inflationary pressures.”
In setting monetary policy, global central banks will no longer be able to claim refuge behind the low-inflation narrative which dominated post the Global Financial Crisis period. With tight labour markets across developed economies, and having potentially stimulated demand into a supply shock, central banks are now being forced to contend with rising inflation which risks becoming embedded into inflation expectations. Collectively this backdrop implies central banks are being forced to revert back to their primary mandate of maintaining price stability, meaning a broadly more hawkish stance for global monetary policy. This has begun to be reflected in short and medium-dated nominal yields. However, bond markets could potentially have much further to travel if the active reduction of central bank balance sheets becomes a more imminent prospect.
We expect the Bank of England will continue to raise policy rates this year, and the Federal Reserve (Fed) will likely begin its hiking cycle in the first half of 2022. While short-dated UK rates have reflected this new environment, the US market looks vulnerable to further repricing as the Fed continues to catch up with the economic narrative. On the contrary, the ECB is divided between those doves pushing back firmly against market (upward) repricing of policy rate expectations, and those hawks who believe Europe is playing with fire and at risk of being behind the curve on tackling inflation. On balance, we believe the ECB will remain a laggard among global central banks, trapped by the fragilities of peripheral nation economies. However there is likely to be a compromise reduction in monetary policy support via reduced asset purchases in the second half of 2022.
While we still see the surge in inflation as largely transitory and expect it to slowly fall this year, the threats to this benign narrative have certainly increased. While we are still confident that base effects will mechanically push down inflation from here, rising wages and stickier inflation through housing etc. pose real risks to the inflationary outlook. Accordingly, we have been reducing risk in our portfolios as central banks increasingly step-up to deal with rising inflationary threats.
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