Inflation: Still transitory, just for longer
Increasing consumer demand, raw material shortages and prolonged supply chain disruptions have combined to ensure inflation has remained abnormally elevated. However, we still believe this backdrop will ultimately prove to be short-lived.
Economists had thought that the peak of US inflation was reached over the summer – it now looks likely that prices will increase further. Used car prices have recently reached new highs and rent prices that make up 30% of core inflation are due to accelerate because of a tight rental market.
In the Eurozone, annual inflation is expected to be at more than 4% at the end of the year – a 13-year high. The European Central Bank has argued that one-off factors such as supply bottlenecks account for much of this surge, and that price growth is expected to moderate in early 20221 . It acknowledges though that the inflationary shock is likely to last longer than previously expected.
We anticipate that US inflation will peak at between 6% and 6.5% before falling back during the first half of 2022. We expect Eurozone inflation to peak around 4.5% in the fourth quarter 2021, and to start to ease thereafter, as supply chain problems recede and demand normalises.
However, when price increases start moderating, we believe they will remain relatively high by historical standards. As such, by this time next year, we expect US and Eurozone inflation respectively to be around 2.5% and 1.5%.
And we are not alone in believing that inflation will not return to zero; the Organisation for Economic Co-operation and Development has warned that it expects prices across the G20 to grow faster than they did prior to the pandemic for at least the next two years.2
Risks to the inflation outlook
While we do believe that higher inflation will ultimately be transitory, it is important to monitor the risks. Forecasting inflation is inherently difficult even for the experts. Prices can be skewed by unexpected or one-off factors such as extreme weather events or sudden shortages – and there are other high-level risks to consider.
For some time before the coronavirus pandemic, many economies had been experiencing a period of moderate growth and moderate inflation. Companies had a clearer view of likely business conditions and as a result, economic cycles have been longer. The pandemic changed all that. As economies have emerged out of lockdowns, there have been periods of “stop and go”, which have made many companies reluctant to expand production capabilities – leading to a more volatile economic and inflation outlook.
At the same time, the drive to ‘build back better’ and to focus on a green transition towards a lower carbon world could push prices of some raw materials higher. However, inflation measures are adjusted to account for the fact that more expensive products can sometimes be of higher quality – a process known as hedonics. If electric vehicles, for example, become more advanced while their cost remains the same, this could actually push inflation lower.
Another risk to global inflation is policy changes in China. As its growth model rotates from exporting to consuming, its role as the world’s factory could diminish – and this could have a significant impact on prices. Meanwhile, the current energy shortage in the world’s second-largest economy is forcing some factories to limit production, which also has an inflationary impact.
The biggest short-term inflation risk that I see right now is the wage-price loop, due to a labour shortage, as economies exit from lockdowns. Wages in many areas are increasing to entice the workforce back – and higher disposable income tends to increase demand for goods and services, making prices rise. Rising prices then increase demand for higher wages, which can create a pricing loop that potentially only ends when interest rates rise.
Monetary policy and investment strategy
While we continue to expect the current inflation shock to prove transitory, we have to concede that “transitory” has become harder to define as inflation has continued to surprise to the upside.
This is setting the scene for central banks to normalise monetary policies – in fact inflation is currently higher than it was during previous periods of monetary policy tightening. The Federal Reserve (Fed) has announced it will pull back its bond purchases by $15bn a month, with quantitative easing scheduled to finish entirely by the middle of 2022.
The Fed has also offered signals about the likely path ahead for monetary policy. Our view is that uncertainty over the labour market may lead the central bank to be more flexible about its definition of “full employment”, particularly in the context of sustained inflation pressures3 . One risk is if the Fed focuses too much on jobs and not enough on inflation it may create a need for more aggressive normalisation later or a loss of control of inflation expectations.
In the UK, persistently elevated inflation had encouraged expectations that the Bank of England might hike in November, but the Monetary Policy Committee held fire, holding rates at the record low of 0.1%. It expects a peak in price rises in the second quarter of 2022, as do we. Our expectation is that inflation falls back below target in early 2023.
With this backdrop, my preference is to hold inflation-linked bonds at the front end of the yield curve – those with shorter maturities - which are potentially better shielded against higher interest rates while still enabling investors to capture inflation accruals.
I also favour short-duration inflation-linked bonds because they have historically had a greater sensitivity to commodity prices. In addition, their total return is more closely correlated to inflation indexation, which we expect to remain supportive in the coming month as inflation continues to be a hot topic.
In the Eurozone, it looks as if quantitative easing has been a permanent feature of monetary policy while inflation is remaining relatively low. This is another risk however, as at some point, policy will change. Holding short-dated French and German government bonds can be a proxy for higher inflation breakevens – the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked bond - while potentially protecting against a policy shift.
In the US, I prefer to hold one to two-year Treasury Inflation-Protected Securities (TIPS) for the positive carry from the bonds’ inflation indexation, but I would rather remain underweight in five-year and longer TIPS that I believe are exposed to the tapering of asset purchases.
Looking back at 2021 so far, the inflation shock has been massive. Earlier this year, economists were expecting Eurozone inflation to peak around 1.5% while it is now likely to peak well above 4%. While we believe that inflation will ultimately prove to be transitory, this year proves that it can surprise to the upside without warning. For now, maintaining a level of inflation protection in investment portfolios could be one of the most appropriate strategies even in the face of the expected upcoming monetary policy normalisation.