Equities trading sideways as anticipation ahead of tonight’s FOMC grows, however overall, recent strength suggests assurance that the Fed is not set to rock the boat and surprise on the hawkish side. Soft payrolls give the Fed the cover to keep a relatively steady hand in face of mounting inflation pressures, but risks are skewed asymmetrically to downside with market quite complacent into the meeting – a slight shift forward in the schedule of hikes may signal hawkishness at the margin.
Meanwhile, the evidence of price pressures continues to accumulate. Yesterday data showed US producer prices rose strongly in May, climbing 6.6% on an annual basis, the largest 12 month increase on record. The monthly change coming in at a strong 1.1% increase on the prior month adding to the outlook for price pressures and pass through.
Last week China PPI data also confirmed this trend of accelerating global price pressures, with producer prices accelerating at the fastest pace in over 12 years. Soaring raw materials and commodity prices continue to filter through with input price pressures causing an ongoing pick up in the PPI.
Chinese manufacturers will either absorb the margin pressure or pass through the price pressures. China’s PPI has historically held a strong positive correlation with US consumer prices and with China being the world’s factory gate, the next big export is inflation. No wonder why the Chinese authorities have upped their ante on containing rising commodity prices. With supply side dislocation remaining and commodity prices set to stay elevated the PPI is likely to remain elevated, increasing the potential for pass through. At any rate it is very clear in which direction inflation momentum is headed as global price pressures gather steam, the jury is still out on whether this is transitory or not.
In the US May consumer prices also came in hot, beating expectations and accelerating at their fastest pace in almost 13 years. However, team transitory took cover in attributing price pressures to Covid induced dislocations as airfares and used car prices spike - the Fed is firmly in control of this narrative and the market continues to buy it, despite mounting evidence of global price pressures continuing to accelerate. The most recent gauge of the ISM manufacturing delivery delays subindex was the highest since the 1974 energy crisis. The services delays index was the third highest in records dating back to 1997. Even as commodity prices dip giving team transitory a win, it is clear supply pressures are still working through the pipeline.
Against this backdrop the path to more persistent inflation remains open as supply remains constrained with demand rebounding aggressively. Pandemic fatigued consumers flush with “stimmy” cheques and accumulated savings are ready to spend. The combination of the two a cocktail for emergent price pressures visible across the goods and services economies as reopening’s continue. Although the 10yr UST yield is subscribing to team transitory, with these dynamics in play it would be reasonable to conclude that price hikes may be sticky. The chasm between reality and the narrative grows ever wider.
According to the most recent NFIB survey a net 40% of owners said they raised average selling prices, increasing 4pp from the prior month to the highest proportion dating back to 1986. Primarily as increased labour costs are being passed through under the cover of rebounding demand, to alleviate margin pressures. Here it is difficult to ascertain what we can attribute to transitory COVID related distortions in the labour market like enhanced UI benefits etc. However, if wages continue to pick up as labour shortages persist and companies bid to attract workers this would be another input in embedding inflationary psychology and perpetuating a more persistent inflation pulse.
Meanwhile the New York Fed survey shows median year-ahead consumer inflation expectations increased to 4% in May, the highest since the data was first compiled in 2013. Inflation expectations edging higher with pent up demand in play again points to price hikes being sticky, another factor embedding inflationary psychology. Expectations in many ways are a self-reinforcing feedback loop for future inflation and less transitory pressures. Becoming a self-fulfilling prophecy if wage and price expectations shift higher through this period. Ironically, if measured core inflation was measured like it was in the 70s, prior to Arthur Burns unknowingly pioneering today’s core indices, it would be running at 14%.
Add in factors like an upshift in rent trends, housing prices have moved sharply higher throughout the pandemic but the owners' equivalent rent of a primary residence, one of the three components of the shelter category has remained artificially depressed. However, as the economy normalises this component of CPI could now keep inflation elevated.
Taken together, although it will take time to separate transitory components from more persistent, the confidence in a transitory outcome is questionable. That said, there remains a lot of noise and unknowns when it comes the interactions of the COVID-19 crisis and stimulus response with the global economy and mass human behaviour. Although we think it is logical to see higher and more persistent inflation, we do not have all the answers and it is perhaps still too soon to draw decisive conclusions.
However, from a portfolio standpoint the risk of higher inflation must be accounted for – it’s no longer a one-way bet. Longer term structural shifts toward fiscal dominance and climate change mitigation could well counter the prior disinflationary spiral of debt, demographics and disruption that has shaped the last decade.
In addition, there is not just 1 inflation story at play here, but 2. Depending on how well anchored inflation expectations can remain and how sticky price increases are against the backdrop of supply dislocations and abundant demand, the dynamics discussed at length above could be transitory. Clearly even in this scenario ambiguities remain on the time frame of transitory and whether longer term expectations can remain well anchored. The longer these price pressures persist the lower that probability.
The other inflation story is a longer-term dynamic, with the pandemic becoming a defining moment in sowing the seeds of change. Covid-19 has assumed policymakers a new mandate to reduce economic insecurity and inequality, with economic policy now prioritising broader social goals. With the aim of bolstering aggregate demand and promoting a self-sustaining recovery driven by the many, not the few. This shift, coined fiscal dominance, brings a world of structurally higher deficits, transfers and benefits and a step up in consumption as new policy frameworks bolster incomes of those with the highest marginal propensity to spend. The Yellen treasury continues to stress the importance of demand side policy in rectifying a K-shaped economy and righting prior policy errors. With a focus on labour>capital, lowering inequality, unemployment and maintaining demand for the bottom leg of the ”K”. In tandem with monetary policy frameworks that are outcome based and reactive over pre-emptive that run economies hotter, it’s a perfect storm for higher inflation. Positioning for this 2-sided risk, inflation protection makes sense. This is the first time in over a decade that inflation has a probable chance of surprising to the upside.
Another longer-term dynamic comes as Governments ramp up commitments to phase out fossil fuels. As the world tries to decarbonise this shift has capacity to bring lasting cost push price pressures. There is no free lunch here! For more on long term drivers see prior discussions. With these shifts in mind, the name of the game in asset markets for now remains one of reflation.
All told, we are not only sceptical price pressures are transitory but also of the Fed’s commitment to stay the course. A Fed pivot looms and the probability the Fed may signal a shift toward tapering of its asset purchases is rising. The Jackson Hole meet in August could well serve as a signalling forum with the potential for the Fed to flag an impending policy shift, with pressure growing to withdraw accommodation as the economy recovers and inflation pressures gather steam. Already the risk that monetary policy is acting too late is growing.