Disrupted supply chains, lower participation rates in the labour market, supply and demand thrown out of kilter. These are among the critical factors that have brought about a sea change in the outlook for US inflation. This regime change will be a critical element in shaping the investment environment in 2022.
This article is part of our Investment Symposium Series, in which we present thinking on the big issues. For this series, we draw on the annual Investment Symposium, a core event where investment professionals at BNP Paribas Asset Management zoom in on the themes shaping the future. It is also a venue for high-level external speakers to cast a new light on the challenges of our time, testing our convictions and diversifying our thinking.
The outlook for US inflation and the appropriateness of US monetary policy were a major focus of our Investment Symposium. Professor Olivier Blanchard explained why, in his view, a secular rise in inflation is underway that will require policymakers at the US Federal Reserve to more severe and rapid tightening of monetary policy.
In this article, we review events so far before providing an outlook based on forecasts from our fixed income team.
Autumn 2021, US inflation takes off…
US inflation as measured by the consumer price index (CPI) hit a headline-grabbing 6.2% in October – its highest in three decades. The Fed’s preferred measure, the core personal consumption expenditure index, rose by 4.1% compared with a year earlier.
Data for November showed the CPI rose by 6.8 % compared to 12 months ago — the fastest annual pace since 1982 and a significant pick-up from October (see Exhibit 1).
Prices between October and November jumped by 0.8 %, slightly down from the previous month-on-month increase of 0.9 %.
According to the Bureau of Labor Statistics (BLS), ‘broad increases in most component indices’ fuelled the rise with petrol, shelter, food, and used and new vehicles ‘among the larger contributors’. Stripping out volatile prices for items such as food and energy, core CPI climbed by 0.5 % from October. That pushed the annual pace up to 4.9% from 4.6% in October.
The factors pushing US inflation higher
Faced with solid demand, US businesses had clearly been raising prices for consumer goods and services steadily, while supply bottlenecks and a shortage of qualified workers were driving up costs.
Our view is that US inflation is being driven primarily by the response to Covid-19. During the pandemic, there has been a huge rebalancing of demand from face-to-face consumer services towards goods, with spending on durables such as cars, appliances and computers increasing particularly steeply. More than three-quarters of Americans made at least one improvement to their home in the first three months of the pandemic, according to Statista.
That demand has encountered supply chain problems in various parts of the world, resulting in widespread shortages and significant upward pressure on the prices of goods and materials, from computer chips to rubber and from coal to medicines. Global freight rates have surged as a result of soaring demand, factors such as Covid outbreaks in ports and the Suez Canal blockage.
Labour markets remain tight
At the same time, Covid has caused extensive disruption in the labour markets – and Americans have been reluctant to return to work.
As well as worries over the risk of contracting the virus, the extremely generous unemployment benefits that helped to support the economy through the crisis have kept workers at home, as have the excess savings households have built up during the pandemic.
US policymakers come under pressure
The rise in inflation in the last quarter of 2021 created an ugly economic situation of weaker growth and higher prices.
The damage inflation does to household purchasing power was stressed by Jerome Powell when he spoke, for the first time after his re-nomination as chair of the Federal Reserve before the US Senate on 30/11/2021. Incoming Fed Vice-Chair Lael Brainard echoed that message.
So the Fed changes course
In the face of the continued upward pressure on prices in the final months of 2021, the Fed clearly became uncomfortable with its current extremely accommodative policy stance.
At the FOMC meeting in early November, it took the first step towards tighter policy, scaling back its asset purchases by USD 15 billion a month. On 30/11/2021, chair Powell said he thought the reduction in the pace of monthly bond purchases could move more quickly than the schedule announced at the start of November.
Up until this point, Fed officials had maintained that inflation would be ‘transitory’, a phenomenon Powell defined as not leaving a lasting mark on the economy. The word appeared in the post-meeting statement at the start of November, but by the end of the month, the chairman said it was probably not useful anymore:
“The word transitory has different meanings for different people. To many it carries a sense of short-lived. We tend to use it to mean that it won’t leave a permanent mark in the form of higher inflation. I think it’s probably a good time to retire that word and try to explain more clearly what we mean.”
A hawkish pivot, drip-fed to investors?
The Fed’s Federal Open Market Committee last met to consider monetary policy on 15 December and delivered what financial markets interpreted at that time as a benign set of measures (see our post here for a full account of their decisions).
However, the publication on 5 January of the minutes of that meeting changed the markets’ perception of the Fed’s stance.
In the view of our fixed income team, the minutes highlight the fact that most FOMC committee members think it appropriate to begin rolling off the balance sheet shortly after commencing interest rate rises.
The market was taken aback to learn that ‘almost all’ FOMC participants believed that the Fed should reduce the size of its balance sheet (that is, start to sell off the bond holdings acquired through quantitative easing) once there has been an increase in its main policy rate.
Overall, we see these minutes as signalling a hawkish shift. The fact that the notion of a simultaneous balance sheet roll-off and rate rises was not evoked by Powell during the question & answer session after December’s FOMC suggests to us that the Fed is seeking to ‘drip-feed’ a hawkish pivot to investors.
Markets reacted by further extending their expectations of forthcoming US rate rises (see Exhibit 2).
Transitory or regime change?
One of the biggest questions for investors in 2022 is whether the low-flation regime in place since the Great Financial Crisis of 2008/09 is now over. During this period, a number of factors combined to keep US inflation unusually low. These factors included:
- Debt – High debt loads discouraged private sector consumption
- Demographics – Aging populations consumed less and saved more
- Globalisation – Offshoring allowed cheaper supply chains to replace expensive onshore labour and production
- Technology – Automation substituted capital for labour; the rise of superstar-companies suppressed labour’s bargaining power.
Today, there are signs of a regime change arising partly from the pandemic. This has accelerated trends already underway. Among the catalysts are:
- Demographics – The falling age of the working population is now reducing labour supply (the baby boom generation is retiring), while demand from older cohorts for services is increasing
- Protectionism – A rise in populism has resulted in rising protectionism; the focus of supply chains is shifting from efficiency to resilience and reliability, which encourages onshoring
- Politics – There is increasing political pressure to address income and wealth inequality, likely through redistributive fiscal policies and higher wages
- Inflation tax on debt – Elevated public debt loads incentivise higher inflation and financial repression
- Fiscal dominance – Central banks may have to accommodate fiscal deficits to deliver on their full employment targets
- Green transition – A rush to build renewable energy production with limited storage capacity and a lack of investment in traditional energy could lead to higher and unstable energy prices.
Watch this space as we chart developments in 2022.