Yes or No?
Introduction and Conclusion
The inflation outlook has become a hotly debated topic in recent months. So far, this has had only a minor impact on financial asset pricing, but bond yields may be a coiled spring at risk of painfully adjusting higher when investors eventually discover inflation is an issue. The market consensus remains that stronger growth will have almost no impact on inflation. Current capital market pricing, including bond yields and longer-term inflation swap rates or breakeven inflation rates, indicate that investors expect inflation will only lift briefly and then recede, remaining well-contained over the long term. This belief is consistent with Federal Reserve (Fed) statements that consumer price pressures will prove transitory. We are not convinced and believe that monetary authorities and investors are too complacent about the pace and durability of the upward move in underlying price pressures.
Our view has been that the U.S. economy will lead in the build-up in global inflation pressures since it already has powerful momentum, is receiving the greatest fiscal stimulus, and has experienced the most robust asset price appreciation. Yet, the Fed remains among the most dovish central banks. The current post-pandemic spike in U.S. core inflation will soon peak but be followed by resilience rather than a return to sub-2% inflation. Indeed, almost all the forces that drive the trend in consumer price inflation are currently contributing to higher price pressures, and many will prove persistent. Most asset classes have re-rated in response to extreme policy reflation, stronger global growth expectations, and plentiful liquidity. Some well-performing asset classes also benefit in an inflationary environment, including shorter-term inflation-protected securities and commodities.
Three Inflation Components
We attempt to break current inflation into three components, although there are significant overlaps. Those components are (1) “transitory” or temporary inflation, (2) supply chain disruption inflation, and (3) core inflation. Our best assessment is that transitory inflation is already fading and will continue to do so for the next several months. Supply chain disruption inflation is proving to be more persistent than many thought and will hopefully dissipate over several quarters. Core inflation, evident in wage rates, is the most controversial part. Our view is this inflation has ticked up and will continue to be problematic after the other two pieces work their way through the system.
The gradual upshift in inflation has been underappreciated by most investors, many of whom have dismissed the recent spike and hold to the secular stagnation narrative. Crosscurrents are likely to muddy the overall inflation picture for the next few quarters. In addition, the base effects of this year’s surge in inflation will work in the opposite direction next year, especially since core and headline consumer prices have jumped much higher than underlying measures of inflation. This could briefly drive the illusion of inflation receding from above 3% in the first half of 2022 until price pressures bottom at a higher run rate than in recent years. According to recent measures, the underlying “sustainable” inflation trend is below 3% but rising. In fact, inflation already exceeds the pre-pandemic rate and rising across a broad set of goods and services, excluding rental inflation. Rent inflation, which tends to be sticky, has been subdued but recently turned the corner and is poised to pick up meaningfully. Shelter is in a unique, sticky cycle with considerable weight in the price basket.
The markets’ reaction to higher-than-expected inflation has been relatively docile as the Fed appears to have done a great job convincing investors (and perhaps themselves) that signs of persistently higher inflation will be transitory. We expect a durable cyclical pickup in price pressures, with the underlying trend of PCE inflation near 3% rather than 2% by the end of next year. This trend will be driven, in part, by the U.S. economy growing faster than expectations - well above the pre-pandemic pace (and the economy’s long-run potential) through the end of next year. A move in inflation from less than 2% to 3% would be a meaningful change for capital markets and investors.