Inflation just printed at 9.1%, the highest level since 1981. But don’t worry, the ever-wise financial markets say, it will fall back to “normal” levels very quickly. Interest rate and commodity markets are currently pricing in a scenario that inflation has peaked and will fall rapidly over the next 24 months. Is it realistic? Why are the markets so confident in this view?
Oil and gas futures are far from their recent highs and remain deep behind. This means that crude oil and natural gas prices should be lower in the future than they are today. For example, WTI crude for August 2023 delivery is 18% lower than August 2022. A similar situation exists for natural gas, where gas for August 2023 delivery is 32% lower than August 2022. that of August 2022.
Other commodity markets reflect a slowdown in demand. For example, industrial metal prices have fallen. The Bloomberg Industrial Metals Index, which includes metals like copper, steel and aluminum, has fallen 42% from its March high.
Inflation swaps predict a sharp fall in consumer prices from the end of the year. Year-on-year inflation is priced at 2.79%. Federal funds and Eurodollar futures predict the Fed will reach a terminal rate of around 3.5% by the end of this year, then begin easing rates in the second half of 2023. Long-term bond yields have fallen sharply over the past month. . The markets seem convinced that inflationary forces have lost their power.
The situation is similar to former President George Bush’s “Mission Accomplished” speech in 2003, where he prematurely declared victory in Iraq; the worst may be over, but the war is certainly not won. Real fed funds rates are still well below current inflation and the Fed, by its own measure, still has a lot of work to do. With fed funds rates expected to peak at 3.5% and then fall rapidly, the market does not give the Fed much time to keep monetary policy in tight territory.
Core CPI could be ‘sticky’
China is not completely out of containment. The demand for commodities could increase once the manufacturing sector is fully operational. In addition, China recently announced a $200 billion spending program to promote local infrastructure growth, which is expected to gradually boost demand.
In the United States, about 70% of US GDP depends on consumer spending. The evolution of household income plays an important role in the health of the economy. The most recent payroll figures and survey data from the Fed’s Beige Book report indicate that labor markets are still showing signs of strength. Yes, a recession will eventually cause labor market weakness, but like Fed policy, it must “go through neutral” to have an economic effect. Economic weakness can allow employers to obtain the labor they have been desperately seeking for several years. In other words, it may take some time before labor market weakness emerges and dampens spending.
Furthermore, consumer balance sheets are in very good shape. Disposable income is still high and debt servicing costs are low. Inflation is eating away at real income, undermining aggregate demand, but consumers are free to increase their debt levels before being forced to cut back on spending. Of course, a severe recession will accelerate the destruction of demand, but in the event of a modest slowdown, a drop in consumer demand could take some time to materialize, preventing downward pressure on inflation.
While many economists focus on the core CPI as a better measure of inflation, the pass-through impact of high energy prices cannot be ignored. In Europe, high natural gas and oil prices have led to soaring electricity costs that eventually affect most goods and services. Russia shows no signs of backing down in Ukraine, and further escalation is possible, including using energy prices as a geopolitical weapon. Energy prices tend to frame inflation expectations, so as long as spot prices are high, survey-based measures of inflation expectations are likely to remain elevated.
Supply relief in the face of soaring energy prices will not happen in the short term. OPEC is operating near capacity and there are few new energy projects expected to come online soon in the United States. Other LNG gas exporters will not help global supply until more LNG terminals come online, which is unlikely to happen for a few years. “With readily available spare capacity that is low both upstream and downstream, it may be up to demand-side measures to reduce fuel consumption and costs,” the IEA summarized in its report on July oil.
The housing situation is also a factor that can keep inflation stubbornly high. Owners’ Equivalent Rent (OER), which accounts for about a third of the CPI basket, continues to catch up with rising national average rents. The CPI measure of housing costs reflects changes in rents for the entire housing stock, not just newly signed leases. Year-over-year rent growth currently stands at 14.1%, according to Apartment List. By comparison, the housing component in the June release of the CPI rose 5.6% on an annualized basis. The OER will continue to rise even if headline rents stabilize.
Financial markets and the Fed don’t have a great track record when it comes to forecasting inflation
At the end of the day, getting a good picture of inflation requires a correct forecast of supply and demand. As noted earlier, there doesn’t appear to be much relief coming from the supply side of the equation for the foreseeable future. Therefore, investors must believe that the global economy will contract enough to bring aggregate demand back to a level that would stabilize prices.
Such a scenario is not excluded. Global central banks are tightening monetary policy, and the fiscal stimulus that provided the surge in demand during the pandemic is long gone. Central banks around the world are tightening policy at an extraordinary pace and leading manufacturing indicators point to a decline in economic activity. A slowdown in economic activity is a near certainty at this point.
Yet why should inflation immediately fall back into its historic range? Even if demand is adjusted downwards, the world will not be the same as before Covid. Structural changes in the economy have taken place. For example, globalization, a major factor that kept inflation low for so long, appears to have reversed.
Covid exposed vulnerabilities in the global supply chain which was constantly searching for the cheapest producer. The private and public sectors are seeking to diversify their supply chains to avoid a repeat of the shortages of essential goods that have caused so much stress during the pandemic. Whether it’s offshoring, reshoring, or simply diversifying, prioritizing supply chain security over cost will result in higher costs being passed on to consumers.
Has inflation peaked? Most likely. After all, inflation is the rate of price change caused by differences between supply and demand. With tighter monetary policy and financial conditions, lower real wages and falling consumer and business confidence, demand is set to fall. However, the rate at which it falls is anything but certain.
The surge in inflation was caused by excessive stimulus coupled with severe supply shortages during the pandemic. The market seems confident that disinflation to pre-Covid levels will come from a gradual weakening of demand alone, with no major supply adjustment.
Markets were surprised by how quickly inflation picked up and were slow to abandon the “transitional” narrative. They may be early in their disinflation prediction.