One of the most important measures of US inflation just recorded its highest reading since the 1990s.
The last time “core” consumer prices in the US were rising at this rate, it was January 1996. John Major was still the prime minister. Tony Blair had been Labour leader for less than two years. Michael Jackson and George Michael were both alive and both had number one hits in the UK that month. Wow, that’s a long time ago.
And now that I’ve made us both feel positively ancient, let’s take a closer look at what it all means for our portfolios.
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The last time US inflation was this high, you were a lot younger
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Last month, the US “core” consumer price index rose at an annual rate of 3%. That was a lot higher than expected. Meanwhile, headline prices (which include volatile things not in the “core” reading, like fuel and food) rose by 4.2%.
All in, it was a big increase. And yes, you can pick at the argument. You can point out (rightly) that there are serious “base” effects here (in other words, prices collapse in April 2020 during the pandemic, so you’d expect them to bounce).
You can also point out (rightly), that almost all of the surge in prices was driven by “reopening” plays. As Michael Pearce of Capital Economics notes, the price of plane tickets jumped, the price of hotel rooms soared, and the price of car rental jumped by more than 16%.
That sort of price rise is a genuine one-off and it’s exactly what you’d expect. When you can’t fly anywhere, a plane ticket is worthless. When you’re suddenly allowed to go on holiday after being stuck in one place for over a year, a plane ticket is, if not quite priceless, as close as it’s going to get.
So it’s easy to see why this surge in demand meeting sectors that have been shut down for 12 months or so has pushed prices up so aggressively. Still. All the analysts and experts already knew this stuff when they were making their forecasts. So either these one-off surges were just a lot more powerful than their models had suggested – or we’re on the verge of something a little more durable than just one-off rebounds.
There are certainly signs – as I pointed out earlier in the week – that US employees are demanding and getting higher wages, even while many people remain out of work. More importantly, they have the popular and political support to do so.
And it’s not just about inflationary forces. A deeper point, made by Louis Gave of research group Gavekal, is that many of the most powerful disinflationary forces – primarily, though not exclusively, the globalisation of trade and the massive expansion of the global workforce – of the 30 to 40 years or so, are behind us now. In other words, there are plenty of inflationary forces and no obvious disinflationary ones to offset them.
Why tech stocks in particular don’t like rising inflation
We can argue about this all day and I suspect we’ll be doing so for some time. But what’s clear is that stockmarkets took the news badly. That’s because they’re worried that higher inflation will force the Federal Reserve, America’s central bank, to raise interest rates earlier than expected. And the worst-hit were the tech stocks, with the Nasdaq index falling hardest on the day.
This makes sense. The problem for tech stocks is that rising inflation is a losing environment for them either way. Even if the Fed doesn’t raise rates to combat inflation, the longer-term value of money still falls (because inflation reduces the value of tomorrow’s money). That spells the end of the tiny discount rates that have been used to justify investing in such stocks at virtually any price, no matter how high.
The corollary of this is that “value” stocks, which are either less reliant on low interest rates or positively benefit from rising ones (such as banks), are more resilient. Hence the “great rotation” continuing. For example, the FTSE 100 managed to end the day yesterday a little higher, despite the tendency of US stocks to set the tone for a day’s trading.
So what’s next? Well, three things can happen. One possibility is that inflation just doesn’t take off. It doesn’t get rooted in the system; it is indeed, a “transient” thing as the Federal Reserve keeps saying. However, that seems unlikely to me. Psychology and politics are shifting; inflation is now expected. In many ways it’s the goal. So if governments can keep spending and inflation still stays low, we’ll just see even more “stimulus” until inflation does perk up.
So let’s assume that inflation takes off. Investors keep pushing long-term bond yields higher. That will present the Fed with a dilemma: it can either accept this, or it can push back. And that means that at some point the US central bank will have to make its position much plainer than it normally likes.
In this case, pushing back will involve admitting that it is serious about allowing inflation to run “hot” because it’s more important that interest rates remain “affordable”. In other words, it will mean the Fed opting for a policy like yield curve control (YCC), whereby the central bank doesn’t just dictate short-term interest rates, but long-term ones too.
To be clear, the Fed is already influencing long-term rates through quantitative easing, but YCC takes it a step further. That’s where the central bank states a specific interest rate target and says that it will buy (or sell) as many bonds as it takes to get the rate to stay there.
The Bank of Japan has been doing this with the ten-year yield for a while now, though in the BoJ’s case (and people forget this) the 0% target wasn’t meant to stop yields from going up, but to prevent them from dropping into negative territory (because the commercial banking sector was already struggling so badly with low rates).
What’s most likely? In this context it’s useful to look at a speech that was being given only yesterday by Fed vice chairman Richard Clarida. He said he was surprised, but that the economy remains “a long way from our goals”.
He also highlighted the weakness of Friday’s jobs report. “Honestly, we need to recognise that there’s a fair amount of noise right now, and it will be prudent and appropriate to gather more evidence.” In other words, we can keep looking through all this for a while yet.
As Pearce over at Capital Economics puts it: “With employment still more than eight million short of its pre-pandemic level, we expect the Fed to maintain its dovish line, even if, as we expect, inflation gains broaden out over the coming months.”
The market is still struggling to wrap its head around this but the goals really have changed. This is a “full employment” Fed, not a “2% inflation” Fed. So one way or another, inflation can head still higher before the spectre of much tighter rates is anything more than just that – a phantom.
We’ve been writing a lot on the implications of all this in MoneyWeek magazine. If you’re not already a subscriber, you can get your first six issues free here.
