Why the inflation spike will prove temporary

Inflation is a firm fixture in the news just now and forefront of most investors’ minds. Justifiably so. Measures of inflation are increasing at rates above central bank targets in most countries and are at or close to decade highs in several major economies.

A key reason is supply chain disruptions. As lockdowns have ended, supply and production has struggled to keep up with a sharp resurgence in demand.

This raises a number of questions:

• Will this elevated inflation prove temporary or long lasting?
• Is the economy headed for a period of stagflation (low growth and high inflation)?
• Could this precipitate faster tightening by central banks?

In our view, a lot of the factors contributing to current above target inflation will start to fade over the next 12 months. In particular, we expect supply chain disruption to improve and base effects will drop out.

We expect headline inflation in some parts of the world to continue to rise in the near term, most notably in UK and Europe given the ongoing energy crisis. The rate of price increases will, however, ultimately revert to a meaningfully lower level than where it is today.

Used car prices and base effects will prove transitory

In the US, used car prices, energy and lodging away from home – while accounting for a relatively small percentage of the total inflation basket – have contributed to at least half of the rise in headline inflation over the past six months. The surge in second hand car prices has almost entirely been driven by the shortage of new cars as a result of the worldwide chip shortage. 

Energy prices could prove to be different, as they can be affected by supply and demand imbalances, but it is hard to see this level of year on year increases in the other categories continuing.

Breakeven levels (market based inflation expectations) indicate investors expect US inflation to average 2.6% over the next 10 years. The Federal Reserve (Fed) has said it will accept a period of above target inflation, in accordance with its average inflation targeting regime, but we are starting to see signs that they think the market has gone far enough in pricing this overshoot.

Other central banks have started to respond to higher inflation expectations and we think the Fed isn’t far behind. Any response should slow and even reverse the move higher in longer run inflation expectations.

There are some elements that point to sustained US inflation, however, notably the strength from housing. Ultimately though, goods price disinflation should more than offset the increase in shelter costs.

In the UK, inflation looks worryingly high and the Bank of England (BoE) is indeed concerned, but this too is a lot to do with the low one year ago comparisons. The support schemes launched in response to the pandemic, such as VAT cuts and the Eat Out to Help Out Scheme, make for decidedly low comparison points. These base effects will drop out, assuming such schemes are not reintroduced, and it is quite plausible headline CPI could be back around 2% late in the second half of 2022.

The elephant in the room is energy, which will cause the BoE to revise its inflation forecasts higher. Gas prices are only one source of higher energy prices and the recent spike we have seen will feed into a higher headline inflation rate in months to come. UK gas tariffs are recalculated bi-annually and will add inflationary pressure when prices are recalculated in April, eating in to household budgets.

This cost-push inflation, as opposed to demand-pull inflation, will likely have a negative impact on growth and limit the scope for the BoE to raise interest rates in the future.

How will central banks respond?

With growth now peaking and the outlook becoming more uncertain, central banks are in a tricky spot. Ordinarily, such high levels of inflation would warrant a central bank response, but continued Covid-related uncertainty and signs of slowing momentum complicates things. Inflation itself could start to weigh on consumption and growth prospects.

Central bankers have faced criticism for raising rates too quickly on several occasions over the past decade. Added to this, the economy and markets are more sensitive than ever to policy and rates.

In order to maintain credibility, certain central banks will have to respond to inflation pressures. The BoE falls into this category, along with central banks in a number of emerging economies. While it surprised the market by not hiking in November, it is still expected to do so in the next few months, purely due to inflation worries.

Comparatively, the Fed and European Central Bank (ECB) have more credibility, having undertaken strategic reviews recently and enhanced forward guidance. The FOMC followed through on its guidance and began tapering in November. It plans to withdraw emergency support at a fairly concerted rate, and we would expect it to stay on course.

However, longer-term, we believe that the impact of higher prices on real disposable incomes will lead to much reduced consumption growth. While we appreciate high level of excess savings could provide some support, the proportion expected  to remain as households’ precautionary saving is unclear. Particularly in the UK and the US, we think this slower pace of growth will alleviate the pressure for interest rate rises in the future.

Global challenges

The inflationary backdrop is having significant implications for emerging markets (EM), a number of which have seen quite aggressive central bank responses. Consumers in emerging economies are now facing tightening monetary policy on top of higher food and energy prices

When it comes to EM currencies, we think the key factor at present is commodity prices and the impact on the relative fortunes of importers versus exporters. Commodities producers are enjoying improving terms of trade, which should be supportive for their currencies.

With some countries having hiked rates significantly, EM local currency bond yields look attractive, but at the moment the overall backdrop is just too challenging. A more favourable  liquidity, inflation and growth backdrop is required to get more excited about local currency bonds.

Like many others, we don’t think a big bazooka fiscal stimulus from the Chinese authorities is on the cards this time. As the main engine of the global manufacturing sector, this means it is hard not to see manufacturing and growth more broadly slowing from here.