US inflation, once again, came in higher than expected yesterday.
It’s been happening so often recently, that you’d think that markets might start to expect that.
Anyway – prices in the US are rising at their fastest rate since 1982. Again. The headline rate of annual inflation hit 7.5% in January.
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And what’s really worrying markets now is that it looks as though the Federal Reserve might try to do something about it.
Inflation is not transitory
There’s really very little room to argue that inflation is “transitory” anymore, regardless of what definition you use.
The “transitory” argument hinges on the idea that once the Covid disruption is behind us and everything is back to “normal”, prices will go back to “normal” too. Supply will rise, demand will ease, and everything will be fine and dandy again (or secular stagnation will return, whatever your preferred view of the world).
One problem with this view is that supply chains keep being disrupted. They’re trickier to untangle than they look, so the definition of “transitory” keeps needing to be stretched. The problem you then have is that this “transitory” inflation starts to feed into “stickier” inflation because someone needs to pay for these higher costs.
There’s another, deeper problem with the “transitory” idea, which is that – I would argue – the world was already on a more inflationary path, and Covid has just interrupted and accelerated that process.
If you accept that the potency of globalisation as a disinflationary force petered out quite some time ago; and if you accept that technological advances might well be less disinflationary for the time being (eg going green is not going to be cheap in the short or medium term); then I think it becomes clear that the pandemic is more an accelerant than a cause.
Whatever your view, the fact is that the price of pretty much everything is rising now. As John Authers points out in his Bloomberg newsletter, services inflation is now at a 30-year high. That suggests that all of the inflation in goods prices – deemed to be a result of the supply chain problems, and thus “transitory” – is now spreading further.
Meanwhile, wage growth is “now above 5% for the first time in 20 years”. Wages and services prices are “sticky” – unlike commodity prices, they aren’t just going to fall sharply because supply improves or recovers.
Now none of this necessarily means that we’re heading for double-digit inflation. If energy price increases ease off (this is not a prediction, it’s just a scenario) then inflation would relax a bit too.
But there’s a big difference between the inflation rate stalling and the inflation rate going back to, or below, the standard central bank target rate of 2%.
In turn, that implies a very, very different world to the one we’ve all lived in for the past 20-odd years, and certainly very different to the post-2008 world.
And yesterday markets started to wake up to what that might mean – particularly for interest rates.
Comparisons with 1994 might be wishful thinking
Following yesterday’s punchier-than-expected inflation figures, investors now expect the US central bank, the Federal Reserve, to raise interest rates much faster and by a lot more than they did just a few short months ago.
It didn’t help that one of the rate-setters, St Louis Fed boss James Bullard, said that he hoped to see a 1% US interest rate by the middle of this year. Markets now fear that the Fed might raise rates by half a percentage point in March, and some were even muttering about an emergency hike between meetings.
Bond yields moved dramatically as a result. Some are even drawing comparisons with the “great bond massacre” of 1994. The ten-year US Treasury bond – the one everyone watches – saw its yield rise back above 2% for the first time since 2019.
What’s the likely reaction?
The Fed won’t want to see a huge amount of volatility or anything that threatens financial stability. A violent spike in interest rates could do that. So we might see some moderately soothing noises if it looks as though things are going to get out of hand.
But in terms of the overall direction, it’s worth remembering that the political calculus is trickier than usual. Inflation is now a talking point for voters – the cost of living crisis isn’t just a problem here in the UK. That means that the US government (and by extension, the Fed) needs to be seen to be doing something about it.
Given the choice between tackling inflation and propping up asset prices, the decision is no longer at all clear. So the usual “Fed put” (the assumption that the Fed would step in to save stockmarkets if they drop) is less potent than it has been for decades.
What will be interesting to see is how the Fed responds if inflation does start to peak later this year, and also what happens once the mid-term elections are over.
The reality is that it’s hard to tackle inflation actively without slowing the economy down. And while inflation is unpopular, so are recessions.
What’s interesting about the 1994 bond “massacre” is that no one really remembers it, because while the turmoil was painful, it didn’t last long. That might seem comforting. A little hiccup on the way to normality.
The problem is, we’re now a lot more indebted, rates are rising from a much lower level, and inflation is on the way up, rather than quiescent, as it was in 1994.
I suspect that the “best-case” outcome now is that inflation stabilises around the 4% mark, interest rates stay about two percentage points below that level, the economy continues to grow, and the debt is gently inflated away without any big shocks along the way.
That’s quite the wish list. Let’s hope we get lucky.
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