US inflation is at a near-40-year high. So why are markets so calm?
US inflation is rising at 6.8% a year – the highest level for nearly four decades. But markets still seem to be taking it in their stride. John Stepek explains why.
Markets spent most of last week awaiting the latest US inflation figures with bated breath. Turns out that in November, US consumer prices rose by 6.8% year-on-year. That's the highest level seen in nearly 40 years.
In other words, we're talking 1980s territory. And the trouble is, back then inflation was still high but falling; we were just getting the 1970s inflation out of the system. This time, inflation is – or certainly has been – low but rising.
The question now is: are central bankers going to be quicker to react this time round, and what does it mean for markets?
We've already seen some market reaction to rising inflation
If you'd been told this time last year that inflation would hit a near-40-year high in the US (and in lots of other places) by the end of 2021, you might imagine a number of scenarios.
You might imagine that the US Federal Reserve and other global central banks would have stopped printing money. You might imagine that the more overvalued markets might have crashed. You might imagine that bond yields would have risen significantly.
To an extent, you'd be right. Lots of global central banks actually have stopped printing money and have started raising rates – just not the important ones.
Some of the most overvalued markets and assets have in fact tanked. You need only look at Cathy Wood's portfolio to see that in the stockmarket. And on the really speculative end of the cryptocurrency world, a lot of the ropiest coins (yes, I know that's a hell of a relative measure I've used there) have collapsed from their highs. So again, we've seen a reaction at the edges – just not in the important stuff.
And bond yields – well, they're higher than they were. But they're not exactly where they'd have been with 6.8% consumer price inflation back in the old days.
You might also have been surprised to note that markets barely shrugged on the back of Friday's reading. But that's no surprise in itself, because the number was pretty much bang in line with expectations.
But what does it say about where we are in terms of both markets and central banks' reactions to inflation? Because those are the things that matter for us as investors.
Markets are still hoping for a smooth landing
What does the current market reaction say about inflation? The most obvious point is that this is not a market that thinks inflation will run out of control. Investors have not dismissed that possibility out of hand (I suspect that if they had, gold would have properly crashed by now, for example). But they're not convinced either.
The market reaction reads more to me as though investors are still hoping for a Goldilocks-style outcome. You'll get a slow but steady shift higher in interest rates. The cycle will peak earlier than before but so will inflation – particularly if supply chains start to clear. And so it's worth reining in bets on the more loopy stuff, but no point in betting on spiking yields or collapsing stockmarkets.
This view is being given added weight by the fact that the Fed seems unusually keen to tackle inflation. The central bank has spent ages being more scared of deflation, and in fact, it only recently changed its policy to emphasise full employment over and above average inflation.
Yet that emphasis has changed. Why? This one is down to politics. President Joe Biden currently has woeful approval ratings. I don't know why that is – politics is local, so my best guess as a British outsider looking in is likely to be wrong. But it's very clear that, politically speaking, a significant proportion of Democrat politicians now see inflation as a problem that could bite them in the mid-terms next year.
No doubt they still recall how Jimmy Carter was perceived to have paid the price for high inflation in the late 1970s, even although he was the one who appointed Paul Volcker – the man who eventually crushed inflation out of the system – as head of the Fed.
What's interesting here – to someone who cares more about the market impact than the politics of it all – is that some types of inflation matter more than others. Wage inflation is good for a politician. If you wake up and you have a pay rise, you're happy, it's a good day. You might even vote for the incumbent as he's clearly doing a good job.
But if you then drive to the petrol station and see that it's costing another tenner to fill up your tank, you don't feel so happy. You think it's time to get rid of whatever idiot is in charge.
So when it comes to it, the inflation that Biden wants to see gone is the inflation at the petrol pump. He's already engineered the release of oil supplies to try to make the difference here and omicron's impact on the travel industry will help too.
But it's also important to be seen to be tough on inflation. So that means talking a big game too.
And in the short run – ie, the run-up to the mid-term elections – I reckon the timing might work for Team Biden. You only need inflation to look as though it's moderating, after all.
Still, that's very different to getting ahead of the problem. In the longer run, I struggle to see how global public debt levels can co-exist peaceably with even moderately higher interest rates.
And if you think Biden (or any other world leader) is keen to crush inflation at the price of causing a recession – well, we're not there yet, simply because voters are not there yet.
So I still think that the market is underestimating the odds of a much more inflationary outcome here. What do you do? Same as we've been suggesting for a while: buy cheap stuff, hold gold, make sure there's cash to hand for capitalising on opportunities as and when they arise.
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