Jonathan Marriott, Chief Investment Officer
Many people have predicted that the enormous stimulus, both monetary and fiscal, applied to counter the pandemic effects, will lead to a steep rise in inflation. Central banks on both sides of the Atlantic have expressed the view that inflation this year will be transitory. Inflation is a key target for central banks when setting interest rates, and interest rates have a direct impact on companies' finances and the overall valuation of equity markets. As a result, investors have been waiting with trepidation for the latest consumer price data from the US Bureau of Statistics. Analysts will be pouring over the numbers for signs that inflation is becoming more imbedded rather than transitory. This month’s headline number was higher than expected, but the jury is still out on whether this is a spike, or more permanent.
Ahead of this week’s numbers, there were signs that the inflation fears had moderated over the last month. Many commodity prices, which had risen steeply, had begun to moderate a little. The front month lumber future was up 148% this year to early March but has since fallen 30% since then. Base effects, that is depressed prices last year due to the pandemic recovering as demand picks up, are clearly significant. Last year, the price of West Texas Intermediate oil was negative when storage filled up and supply exceeded demand. Last month’s headline Consumer Price Index (CPI) was 4.7%, well above market predictions; and this month, headline CPI hit 5% with core inflation at 3.8%. According to Bloomberg, over 50% of the rise this month came from factors related to reopening the economy, as it did last month. Second-hand car and truck prices were up 7.3% on the month, and 29.7% since last year. Last year, hire companies cut their fleets depressing prices, and as people get back on the road for the summer, demand has picked up. Transportation, eating out and lodging costs also rose. So, plenty that the Federal Reserve may see as transitory.
Commodity price rises tend to be cyclical, as the build-up of supply lags price rises, and cuts in production only come after prices have fallen. The pandemic has accelerated this cycle dramatically. The same can be said of the supply of electronic chips, which was made worse by a fire at a factory in Japan in March. If we are looking for longer duration inflation this may come in the form of wages. While the CPI has reflected a strong recovery above expectations, the US non-farm payroll figures while positive, have come in below expectations in recent months. However, job openings are at record highs at 9.28 million, close to the 9.31 million unemployed workers. This may reflect that those available for work do not have the right skills or are not in the right place. Even this may not be inflationary; pre-pandemic, in 2018/19 job openings exceeded supply, and unemployment was at record lows, and yet there was little sign of inflation.
The Federal Reserve has a 2% inflation target, but they revised this to an average inflation rate, so do not have to respond to a transitory pick up. They have also said that they target full employment, particularly for minority and disadvantaged groups. They have also indicated that they are outcome based. All this may indicate that the Federal Reserve may be behind the curve as the economy recovers. However, as they changed the wording to encourage the recovery, there may be subtle changes that means they will respond faster should the economy look as if it is getting out of hand.
The European Central Bank met this week and reiterated their view that inflation is transitory. A cut in VAT in Germany, which has now been reimposed, will add to the annual inflation rate in the months to come. However, the ECB expects inflation to be back down to 1.4% in 2023. In the UK, we will get the latest inflation data next week, which may show a pickup albeit less than the US. Due to fuel taxes in the UK, the inflation numbers are less sensitive to the oil price, and the rise in sterling this year will help to moderate the inflation rate. The furlough scheme has kept unemployment low, and anecdotal evidence suggests that the hospitality industry is struggling to fill jobs as it reopens. In London, this may mean that low paid workers have moved away during lockdown so are no longer available.
My own view is that demographic shifts, automation and other technological developments will moderate long term inflation, and that the present spike will prove to be transitory. The pandemic hangover of higher debt will make the economy more sensitive to rising rates which means that any withdrawal of monetary stimulus may be very gradual, and the next peak in rates lower than during the previous cycle. Raising rates may be even harder for central banks where governments apply fiscal tightening in an attempt to reduce deficits. The US bond market had risen before this week’s CPI announcement, and the inflation rate priced into US Treasury Inflation Protected securities (TIPs) had come back from their highs last month only slightly higher. Despite the unexpected high headline number, the rates were little changed perhaps reflecting a view that the rise may be transitory after all.
 Source: Bloomberg
 Source: Bloomberg
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