July 15, 2021
The economic reopening after the pandemic was always going to produce a pop in GDP numbers and as we have seen, inflation usually rides on the coat tails of growth. Until now, central banks, particularly the Fed, managed to convince the market that the spike in prices would be transitory – caused by an amalgamation of factors such as supply chain bottlenecks, base effects, and pent-up demand. As such, the Fed said it would be premature to tighten monetary policy, noting that labour market data clashes with the idea that a broad-based recovery has been pulled-off.
However, the “transitory” narrative came under further pressure last week with US CPI coming in at a staggering 5.4% in June compared to a year earlier, the fastest pace since 2008 (+0.9% month-on-month). Following the data release, Jerome Powell, the Fed Chair, was grilled at a Congressional hearing, with Democrats and Republicans alike asserting that their constituents are feeling adverse effects from higher prices, and questioning how transitory “transitory” will be. Some commentators are afraid that if central banks are too blasé about higher inflation, it could evade their control, resulting in 1970s-style inflationary spirals.
Though he acknowledged inflation that has been “higher than expected and hoped for”, Powell defended the Fed’s position and sought to ease concerns that the Fed may be too complacent in the face of inflation, saying that he still views the US economy as “still a ways off” from having made the ‘substantial further progress’ in order to slow asset purchases. Albeit, this will be discussed at the next FOMC, scheduled for July 27-28.
“It is still the same story. It is still the same parts of the economy that are producing this inflation. It is a pretty narrow group of things that are producing these high readings, but we are anxious like everybody else to see that inflation pass through. We really do believe and virtually all forecasters do believe that these things will come down of their own accord as the economy reopens — it would be a mistake to act prematurely”, said Powell.
Indeed, the inflation print was largely driven by price increases in specific pockets of the economy. Used vehicle prices, for example, rose 10.5% in June from the prior month – the most on record – while new car prices rose 2% in the same period – the biggest rise since 1981. These gains in the auto market accounted for more than half of the monthly increase in core CPI and are largely due to bunged-up production lines, stemming from the ongoing semiconductor shortage, as well as car rental firms rushing to replenish their fleets. Other pandemic-sensitive components such as airfares and hotel rates continued to rocket too (up 2.7% MoM and 7.9% MoM, respectively, in June). Powell referred to the price action of lumber, which is now trading at 8-month lows after rallying +200%, alluding to the fact that this could happen to many of the transitory factors.
Nonetheless, certain high-profile commentators appear to be shifting to the view that higher inflation is here to stay. Blackrock CEO Larry Fink this week commented that he does not rule out inflation staying above 3%, on the back of higher energy costs, global supply chain disruptions and the Federal Reserve’s laser-focus on the labour market. His company has just awarded the majority of its employees an 8% pay rise.
Above-target inflation is not merely a US phenomenon, it is prevalent the world around. For example, UK inflation hit 2.5% YoY in June, its highest level since 2018, compelling the Bank of England’s Ramsden to state that conditions for tightening policy could come sooner than expected in the forecasts of May.
Inflation has also picked up in the eurozone, but not to the same extent, receding slightly to 1.9% in June. Europe is still relatively behind in its reopening, while technical effects are also at play. German value added tax was temporarily cut in the second half of 2020 but that has now been reversed, a change which will be partially reflected in the overall figure from July.
The elephant in the room for investors is whether pockets of price inflation are adequately contained. For now, we maintain our view that they are and that price pressures will be temporary, even though June figures hint that, even if transitory, this period of galloping inflation in the US economy may be longer and more pronounced than previously thought. We think spiraling inflation is unlikely, especially while there are few indications that wages are on the rise.
Ultimately, we think that inflation will settle in central banks’ comfort zones – probably higher than in the last cycle when it was notoriously low. Likewise, market measures of inflation expectations do not suggest broad-based concerns about runaway prices, even if they have moved moderately higher in recent days.
For now, Powell has consoled markets, with core bond prices rising in the wake of his Congressional hearing. He managed to snap a three-day sell-off that was catalysed by the unexpectedly high US inflation print and a long-dated Treasury auction that was met with dampened demand.
Author: Group Investment Office