The US president has expressed his desire to tackle rising prices, but we expect his namesake meme to rumble on for a while.
US CPI surprised materially above expectations once again this week, as the core CPI reached a new high at 4.6% and the headline moved up to 6.2%.
Government bond yields rose in the wake of this but having rallied in the earlier part of the week, were little changed over the past seven days. It seems that this is largely a result of the seemingly unshakeable assumption that the move up in inflation will prove transitory.
In many respects, we find this faith in prices reversing lower to be pretty surprising. We can easily see how prices could continue to move higher in the months ahead, with ever more negative real rates meaning that monetary policy becomes more accommodative, even if the Fed is set to begin to taper its QE purchases. It strikes us that it has been such a long time since many market participants have seen inflation, that there is an underlying assumption that it must be an aberration or temporary anomaly. We see this assessment as fundamentally flawed.
The longer inflation remains elevated, so the demand from workers for higher wages becomes more entrenched. Similarly, corporates will become increasingly comfortable exacting pricing pressure and passing higher prices onto consumers.
Consumer balance sheets are healthy and there is little sense that inflation is leading to any slowing of demand at this point. With a number of workers having withdrawn from the labour force, we believe that the unemployment rate may not move as low in the current cycle as we saw in the prior cycle, hence we may already be close to full employment. Indeed, surveys such as JOLTs point to a relative abundance of job openings and softness in the NFIB survey was squarely attributed to an inability by firms to hire all the workers they need.
One former US policymaker shared with us this week that hourly rates for waiting staff at his favourite restaurant in Vail, Colorado have now topped USD60 per hour. He also observed how corporate contacts are sharing how they have been relatively tentative in pushing price hikes through in 2021 but are planning bigger hikes for 2022 as they seek to pass on costs.
Higher inflation is not only a US phenomenon. PPI prices in China were recorded up 13.5% over the past year. We have also seen a slew of emerging market countries reporting further price gains, following on from higher energy prices over the past month.
However, in the US, we would observe that demand seems set to continue to outstrip supply. Basic economic analysis would suggest that these are conditions that can see rates of inflation continue to move higher, unless or until policy restraint is forthcoming. When inflation rises, there is a temptation to spend cash as it is literally burning a hole in your pocket if real rates are in deeply negative territory.
Some may explain low bond yields in the context of a march towards secular stagnation, which could imply that the equilibrium R* interest rate has dropped to zero or below. Yet, this bearish interpretation, which has pushed 30-year real interest rates to -0.6%, seems at odds with an equity market that has been posting record historic highs.
Perhaps a more realistic interpretation is that there is simply too much liquidity in the system and there remains too much money chasing too few assets. If this is the case, then this could be another reason to fear that inflation can continue to run ahead in the period to come.
Inflation doves may argue that technology continues to drive prices down. Yet a focus on ESG and net zero could negate this by pushing prices in the other direction, as these policies will exert an inevitable cost.
Moreover, globalisation is running in reverse, demographics are turning and the application of fiscal policy has become much more expansive than we have seen for decades. Meanwhile, central banks have simultaneously moved away from established policy frameworks to adopt more of a flexible average inflation target approach, tolerating overshooting inflation, when in the past they may have taken a pre-emptive stance to combat this.
Of course, there is a scenario in which inflation could moderate of its own accord later next year. But this seems to be growing increasingly unlikely, in our view. It strikes us that the longer and greater the magnitude of the overshoot in the near term, the more inflation expectations are starting to adjust and we should expect to see higher wages driving second-round price effects.
Bluntly speaking, if policymakers fail to act and are left asleep at the wheel, there is a growing risk that inflation will only trend higher. We now think that US CPI could approach 8% early in 2022 with core prices well above 6%. It is hard to know when the Fed may blink. Maybe the Fed is taking reassurance from market pricing based on a benign outcome, largely because it is taking reassurance from the Fed. Yet for as long as the FOMC delays hiking, we think that longer-dated forwards (which have flattened materially) should begin to move decisively steeper.
Were Brainard (who is seen as a policy dove) to be appointed as Fed chair, we ultimately think this steepening should be even more pronounced. We remain confident that a short-duration stance in the 10-year point on the yield curve is the correct position to take and are happy to remain patient, even if there is little to cheer about in the near term regarding this position.
Away from the US, European markets await further hints ahead of the December ECB meeting. Meanwhile, there has been little progress in forming a new coalition government in Germany and it is yet possible that we see new elections take place. UK yields have risen somewhat after last week’s dovish BoE surprise and we think there is scope for UK price gains to accelerate even more quickly than we are seeing in the US over the course of the next few months.
Credit markets were also quiet over the past week, mirroring low volatility in equity markets. In a few weeks’ time, liquidity will continue to dry up going into year-end and so the new issue market remains active for now, but we are starting to pass the peak issuance season.
Elsewhere in FX, improving data saw the dollar continue to strengthen, yet for now, volatility in FX markets remains modest compared to gyrations in rates markets.
We expect that the inflation narrative will continue to dominate attention. It has been interesting to observe how higher prices are becoming a more political issue, with policymakers starting to feel the heat.
Accusations that we are seeing ‘Bidinflation’ saw the US president comment on his desire to tackle rising prices. Whether this impacts his choice with respect to the Fed chair remains to be seen. Progressives in the Democrat Party, and notably Elizabeth Warren, have championed the nomination of Lael Brainard. However, as a perceived policy dove, it strikes us the Joe Manchin may object, potentially blocking the confirmation of Brainard, if Biden puts her forward. Hence a re-nomination of Powell seems the most likely outcome and we may expect to hear Biden’s decision on this in the next few days.
Moreover, following the loss of the governor race in Virginia, we sense that progressives are on the retreat and that the Democrats may be heading back towards the centre. We still foresee substantial losses at mid-terms later in 2022 and Biden as a lame duck by this point. It is interesting to observe that in Republican circles, Trump is still looming in the background.
High inflation typically hurts the poor, though ironically it could encourage a return to the labour market for those who have dropped out of the workforce. Consequently, we foresee relatively solid data on jobs and prices in the next few months. It would not be too surprising to see the Fed materially revise forecasts at its December meeting, with a chance that it may look to bring forward the end of taper from June to March. Expect the ‘Bidinflation’ meme to continue to trend for some time to come.