Strategy blog: Inflation – passionately unconvinced

The best lack all conviction, while the worst are full of passionate intensity”

W.B. Yeats

Strategy team: Kevin Gardiner

Inflation continues to gather momentum. In the last week we’ve seen US and UK October CPIs ahead of expectations at 6.2% and 4.2%, 31- year and 10-year highs respectively.

Earlier in the month, we saw Germany’s CPI inflation at 4.5%, a 28-year high; France at 2.6% (13-year); Spain 5.4% (29-year); Italy 3.0% (9-year). Switzerland seemingly remains relatively insulated, at 1.2%, though even this is still flirting with an 11-year high.

China’s inflation is relatively low at 1.0%, but it is following a slightly different cycle, and wholesale prices suggest more to come. Among the larger economies, Japan’s CPI looks most inert – but it has done so, more or less, since 1995: not so much a different cycle as a different model.

At these sorts of levels, inflation starts to be more noticeable.

Most visibly for savers: with no interest rates, the real value of bank deposits falls by the inflation rate, and a nominally stable asset has in some cases lost around a twentieth of its worth. This is especially unsettling in Germany, with its long collective memory of an unhappy monetary history.

But it also starts to be more visible to businesses and households worried about input costs and spending power – especially as it partly reflects some very visible production bottlenecks and shortages.

In just over eighteen months, as we’ve noted, consensus opinion has flipped sharply: from fear of mass unemployment and deflation, to talk now of a sustained bout of inflation or even stagflation (if those shortages persist, and output is unable to keep growing).

We have always seen inflation as more likely – and potentially more damaging – than deflation. We have worried that central banks’ groupthink, mission-creep and a reluctance to be unpopular could at some stage put the last quarter-century’s hard-won monetary credibility at risk. And we thought the collective response to the pandemic would amplify these risks.

That said, the higher inflation we have been braced for (and positioned for, in terms of top-down investment advice) has been moderate in scale (a trend rate of 2-4%, say, across the big developed economies, compared to the 1-2% pre-pandemic norm) and accompanied by ongoing growth.

The immediate surge in inflation has certainly been sharper, and is taking longer to peak, than we’d guessed. If we made short-term economic forecasts, our estimates of 2021 G7 inflation would have been too low, by perhaps 1-2 percentage points.

And with energy and US housing (“shelter”) costs yet to peak, and shortages of key inputs unlikely to vanish overnight, the short-term risks feel as if they are still tilted to the upside. Of late, it has indeed felt as if it’s “just one thing after another”.

So we’re not fighting the tape – we’re in that inflation chatroom too. With shortages and disruptions so widespread, who can call the exact top with confidence?

But we have not yet changed our assessment of the medium and long-term outlook. We think inflation will eventually settle in that 2-4% range: higher than it was, but lower than it is today. The 10-year break-even rates priced into the main inflation-indexed bond markets are rising, but are firmly inside a 1-4% range (the UK’s 4.2% seems an exception, but it refers to RPI inflation, which is typically a percentage point higher).

Some of today’s shortages will fade as mining, energy and shipping capacity (for example) is added, and as labour force participation rebounds: some lifestyle changes may not last far beyond the withdrawal of pandemic support. The Fed may be stretching the meaning of “transitory”, but they have a point.

Today’s big economies may be less inflation prone than they used to be: industrial relations are better, labour supply has risen with China’s greater participation in the global marketplace, and output is more digital.

And we do think our consensus-gripped, increasingly ambitious and affection-craving central banks will eventually start to do the right thing with policy rates.

More prosaically, base effects will turn benign: much of the recent rapid ascent will translate into friendly year-ago comparisons and equally rapid declines in due course. And the surge in money supplies – not our main concern, but part of the potential inflationary mix nonetheless – is looking more and more to have been one-off, rather than ongoing.

This could sound like wishful thinking (though again: we have been positioned for an inflation upturn for some time – we don’t feel like quite such stale bond bears now). But while we cannot pretend to have knowledge of the future, we think we have some understanding of today’s news industry. The calls for more dramatic inflation now sound just as confident as did the deflation calls in spring 2020.

In particular, we doubt whether significantly higher long-term inflation expectations have already become embedded among consumers and workers, whatever the surveys of current (fickle) opinion may seem to suggest. It’s simply too soon to say.