Inflation just printed at 9.1%, the highest level since 1981. But don’t worry, sayeth the ever-wise financial markets, it will fall back down very quickly to “normal” levels. Interest rate and commodity markets currently price in a scenario that inflation has peaked and will rapidly fall over the next 24 months. Is this realistic? Why are markets so confident in this view?
Oil and gas futures are well off their recent highs and remain in deep backwardation. That means prices for crude oil and natural gas are expected to be lower in the future than they are today. For example, WTI crude for Aug 2023 delivery is 18% lower than for Aug 2022. A similar situation exists for natural gas, where gas for Aug 2023 delivery is 32% lower than Aug 2022.
Other commodity markets reflect a slowdown in demand. For example, Industrial metals prices have plummeted. The Bloomberg Industrial Metals index, which includes metals such as copper, steel and aluminum, has fallen 42% from its high last March.
Inflation swaps predict a steep drop in consumer prices starting later this year. One year inflation in one year is priced at 2.79%. Fed funds and Eurodollar futures predict the Fed will reach a terminal rate of around 3.5% by the end of this year and then start easing rates in the second half of 2023. Long-term bond yields have made a significant push lower in the last month. Markets appear convinced that inflationary forces have lost their power.
The situation is akin to former President George Bush’s 2003 “Mission Accomplished” speech, 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 significantly below current inflation and the Fed, by its own measure, has a lot more work to do. With fed funds rates expected to peak at 3.5% and then quickly fall, the market is not giving the Fed much time to keep monetary policy in restrictive territory.
Core CPI could be “sticky”
China has not fully emerged from lockdown. Commodity demand may increase once the manufacturing sector is fully operational. In addition, China recently announced a $200 billion spending package to promote infrastructure growth at the local level, which should provide an incremental demand boost.
In the U.S., roughly 70% of U.S. GDP depends on consumer spending. Changes in household income play an important role in the economy’s health. The most recent payroll numbers and the survey data from the Fed’s Beige Book report indicate that labor markets still show signs of strength. Yes, a recession will eventually lead to weakness in the job market, but similar to Fed policy, it has to “go through neutral” to have an economic effect. Economic weakness may allow employers to get the labor they have desperately sought for the last couple of years. In other words, it may take some time for weakness in the labor market to emerge and cause a drag on spending.
Besides, consumer balance sheets are in great shape. Disposable income is still high and debt servicing costs are low. Inflation is eating into real income, sapping overall demand, but consumers have plenty of room to increase debt levels before they are forced to cut back on spending. Of course, a severe recession will accelerate the demand destruction, but in the event of a modest slowdown, a drop in consumer demand may take some time to materialize, preventing downward pressure on inflation.
While many economists focus on core CPI as a better inflation measure, the pass-through impact of high energy prices can’t be ignored. In Europe, high natural gas and oil prices have led to a spike in electricity costs that eventually spill over into most goods and services. Russia shows no signs of backing off in Ukraine, and further escalation is possible, specifically using energy prices as a geopolitical weapon. Energy prices tend to frame inflation expectations, so as long as spot prices are elevated, survey-based measures of inflation expectations will likely stay high.
Supply-side relief from soaring energy prices will not happen in the near term. OPEC is running output near capacity and there are few new energy projects set to come online in the U.S. soon. Additional LNG gas exporters won’t help global supply until more LNG terminals come online, which is not set to happen for a couple more years. “With readily available spare capacity running low in both the upstream and downstream, it may be up to demand side measures to bring down consumption and fuel costs,” the IEA summarized the situation in its July oil report.
The situation in housing is also a factor that may keep inflation stubbornly high. Owners’ Equivalent Rent (OER), which makes up roughly a third of the CPI basket, is still catching up to the rip higher in national average rents. The CPI measure of housing costs reflects changes in rents for the overall housing stock, not just newly-signed leases. Year-over-year rent growth currently stands at 14.1%, according to Apartment List. By comparison, the shelter component in the June CPI release increased 5.6% on an annualized basis. OER will keep rising even if headline rents stabilize.
Financial markets and the Fed do not have a great track record in predicting inflation
Ultimately, getting the inflation call right about inflation requires a correct prediction of supply and demand. As previously noted, there does not appear to be a lot of relief coming from the supply side of the equation in the foreseeable future. Therefore, investors must believe that the global economy will shrink enough to bring down aggregate demand to a level that would stabilize prices.
Such a scenario is not out of the question. Global central banks are tightening monetary policy and the fiscal impulse 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 declining economic activity. A slowdown in economic activity is a near certainty at this point.
Still, why should inflation immediately fall back into its historical range? Even if demand is adjusted downward, the world will not look the same as it did 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 the vulnerabilities of the global supply chain that constantly sought out the lowest-cost producer. The private and public sectors are looking to diversify their supply chains to prevent a repeat of the shortages of critical goods that caused so much stress during the pandemic. Whether it is nearshoring, reshoring, or just diversification, prioritizing the security of the supply chain over cost will lead to higher costs that will be passed on to consumers.
Has inflation peaked? Most likely. After all, inflation is the rate of change in prices caused by differences in supply and demand. With tightening monetary policy and financial conditions, lower real wages and plummeting consumer and business confidence, demand is destined set to fall. However, the pace at which it falls is anything but certain.
The spike in inflation was caused when excessive stimulus was paired with severe supply shortages during the pandemic. The market appears confident that disinflation to pre-Covid levels will come from a gradual weakening in demand alone, without a major adjustment to supply.
Markets were surprised by how quickly inflation accelerated and were late in abandoning the “transitory” narrative. They may be early in their prediction for disinflation.