Annual inflation indicators survey |Linchpin
This is Linchpin’s eleventh annual update on the long-term outlook for inflation, in which we monitor a range of inflation indicators. Last year, we saw supply-side pressures rising in food and commodities, but despite a nod to the geopolitical risk Russia posed, we failed to predict how the war in Ukraine would boost inflation to multi-decade highs. The question for investors today is how much and how soon it will come down.
William Bourne
Monetary policy unable to constrain supply-side inflation in 2022...
We concluded last year that the supply-side rise in inflation was on balance still a blip, but Russia’s invasion of Ukraine threw our calculation off course. It not only directly impacted commodities such as wheat and energy, but also led the West to reassess the resilience of its supply chains, with inevitable associated costs. COVID’s aftermath has had its effect too, as workers retired earlier, and Chinese lockdowns disrupted production.
Consumer inflation has risen to multi-decade highs globally, despite G7 monetary policy tightening very significantly. As well as raising interest rates by 425bps, in 2022 the Federal Reserve withdrew around US$1trillion from its balance sheet. And yet inflation remains stickily high in most major economies. Japan is the exception, where inflation remains below 3%, albeit significantly higher than a year ago.
This monetary tightening has clearly reduced demand, and most economies look certain to go into full recession in 2023. The United States may possibly be the exception. The problem for the authorities is that using policy to squeeze demand has so far not affected an inflation surge which is largely caused by supply-side factors.
The net score from our 12 indicators moved away from inflation at +1 (+3 in 2021), with five indicators pointing to inflation, three to neutral, and four to deflation. This may seem counterintuitive, but reflects central banks’ attempts to rein inflation in. Liquidity creation (policy action) has moved from neutral to deflation and leverage (demand) from inflation to deflation. On the other hand, the rise in bond yields at least in theory signals that markets expect higher inflation, though we note that implied inflation (i.e., the difference between the 5-year index linked gilt real yield and conventional bond yields) has fallen over the past twelve months in both the U.K. and the U.S. We commented last year that gold, our final market-based indicator, has lost some of its allure as an inflation-hedge to crypto-currencies. Following the collapse of some of the latter in 2022, investors seem to be turning back at least in part to gold. While the price is still 10% below its peak, it is rising and we have therefore kept it as signalling inflation. ...but supply-side inflation is abating Our supply side indicators last year all pointed to inflation. This year the picture is more mixed. Energy prices and have fallen in the past few months as consumers have reduced demand and new sources come on stream, so crude oil (for example) is now only modestly higher than a year ago. Many food and industrial metal prices have also come down: wheat futures are at a 12-month low, albeit still 50% higher than pre-COVID, but others such as soya beans have not fallen back as much. We have therefore moved this indicator back to neutral. On the other hand, labour costs look set to rise, as a cohort of workers chooses to retire after the COVID-related lockdowns, and trade unions flex their muscles. Further out, demographics means that the supply of workers in countries such as China will soon start to decline, and we can expect labour to take a greater share of income. Politics is also moving in the same direction of levelling up. In theory there is spare manufacturing capacity in the world, but the world is moving to a new way of operating with less reliance on fossil fuels or offices and some capacity may well turn out to be redundant. In this context we note the US Chips and Science Act of 2022 which will cut off U.S. industry from some Chinese capacity and vice versa. Finally, as we noted last year, in some key areas such as semi-conductor chips there is a lack of capacity, so we have kept this indicator as inflationary. New demand will depend on government spending Demand indicators are unsurprisingly largely pointing to disinflation. Private demand is being throttled back savagely by a combination of higher energy and food costs, higher taxation, and higher costs of borrowing. Governments may become a new source of demand, especially in areas such as military spending and infrastructure, but they will be constrained by their ability to borrow. For example, markets successfully derailed the Truss Government’s attempted move to much looser fiscal policy. However, governments tend to be less price-conscious than private purchasers, and that of itself can turn out to be inflationary. Monetary policy will pivot to a looser stance Monetary policy, as we commented above, has tightened very substantially, but there are clear signs of this phase coming to an end. The Federal Reserve will pivot to looser policy at some point, although it may not be till the second half of 2023. The other important actor here is China. For much of 2022 the PBOC kept policy tight, but in the last quarter, against the background of COVID lockdowns and a super-strong US dollar, they eased again. Their future stance is likely to be looser rather than tighter to maintain growth in their economy. However, we have kept this indicator as deflationary because any pivot will be dependent on inflation being under control. Current market inflation estimates The forecast 2022 end-period inflation rate at the IMF G7 group is 6.8%, compared to 0.6% at end 2020. The range is from Japan (2.4%) to the U.K. (11.3%). The deflator stands at 5.4%, with a range from 9.2% (Canada) to 0.3% (Japan). According to the IMF there is no output gap in aggregate, with only Japan showing a small one at country level. The IMF’s estimates of future inflation converge back to 2%, with even the U.K. back in line by 2025. It is not clear whether this is a function of mean reversion or their own active forecasting. Inflation to come down to a 3% to 5% range, but the risks are on the upside Last year we took the view that inflation would not find its way into consumer psychology and would therefore drop back to the 2% targeted by many central banks. Subsequent events overtook our forecast, and workers’ psychology seems to have changed. The increases in food and energy prices have led to demands for wage increases of a similar level. In our view, that genie cannot easily be put back into its bottle. It is therefore surprising that market-derived forecasts are expecting inflation to drop back to around 3%. Some of this may be due to distortions in the fixed income markets, but in theory investors expect U.S. inflation to be at about 2.3% and the U.K. at about 3.3% in 2027. In practice, we can add something to that to allow for the inflation risk premium (i.e., the value to investors of being able to hedge the inflation risk by investing in index linked gilts), but with the utmost charity we doubt it is more than, say, 1%. The crunch will probably come in food prices. Unlike energy, there are no obvious sources of food to replace that lost through the Ukraine conflict. While 2022’s 10%+ rises may be a once-off, there are signs that producers are under considerable strain, and it is likely that food inflation will continue at levels significantly higher than pre-COVID. If that happens, we suspect that the psychology of inflation will lead to higher labour costs as labour demands a higher share of corporate income. We therefore conclude that inflation may not stay at 7%, but will stay higher than we have become accustomed to, perhaps in the 3% to 5% range. Japan may be particularly affected by this dynamic, as consumers will be waking up from 30 years of deflation when labour’s bargaining ability has been almost zero. We would not be surprised if Japanese inflation were an outlier at the top end over the next two years. Events may knock us off course, as they did in 2021. A resolution to the Ukraine crisis still looks a long way away, and it could worsen. Equally, central banks may not be resolute enough to maintain their stance against inflation during a deep recession. We agree with the consensus that the risks are on the upside. If you would like to discuss anything in this article with the author, please visit our website at www.linchpin-advisory.com or contact us on research@linchpin-advisory.com. 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