The inflation data in the US and globally continues to deteriorate and worry investors. The latest readings showed the US consumer price index (CPI) at 7.5 per cent, once again above expectations. Below the headline numbers, the data was even more concerning.
The Cleveland Fed produces a trimmed mean (excluding the highest and lowest outlier data points) giving a good sense of the underlying trend. This data series is at a 40-year high. The Atlanta Fed produces a series where they break inflation into sticky and flexible components. As expected, the flexible prices component is off the charts, rising exponentially and demonstrating the supply chain issues and surging commodity prices.
It is a fair assumption that these prices will normalise over time. Unfortunately, even the sticky prices component is now rising and is at a 30-year high. This is far more worrying and something the transitory inflation camp is watching nervously. While it is almost certain headline inflation will decline in the coming months, given the exponential rise in the flexible prices component, this does not by any means guarantee prices will come down to the Fed target of 2 per cent anytime soon. Rental inflation (over 33 per cent weightage in CPI) has also been rising and will need to be closely watched as it resets to last years’ surge in house prices. If this series breaks out, it will be almost impossible for inflation to come down to 2 per cent in the absence of very significant monetary policy tightening. The Federal Reserve will have to act in such a scenario.
On wages, the Atlanta Fed released scary data on Friday showing wages rising by 5 per cent, driven by the lowest income cohorts as employers are trying to attract workers back into the job market.
All these data points are naturally spooking the bond markets, and therefore equities as well. The two-year treasury yields (most sensitive to changes in monetary policy) have spiked and risen from 0.2 per cent in September of last year to 1.6 per cent today. The 10-year treasury yield has crossed 2 per cent and is threatening to break the well-established downward sloping trend line for yields beginning 1982. Any break above this trend line can cause chaos across asset markets. The yield curve (10-year and two-year ) which had a positive spread of 150 basis points in the recent past has now declined to only 50 basis points, probably on its way towards inversion, the classic indicator of an upcoming recession.
There seems to be a rush among economists and the market itself to catch up with rising inflation expectations and inflation numbers consistently worse than consensus. Most market participants now expect at least 5 rate hikes in 2022, with a 40 per cent chance of a 50 basis points hike to begin the cycle.
With core personal consumption expenditures inflation at about 5 per cent, compared to a Fed target of 2 per cent, the clear debate is how much of this 300 basis points gap is cyclical inflation and how much is Covid/supply chain related, which will naturally correct over time as things normalise? This distinction is important as cyclical inflation will need the Federal Reserve to slow down and cool the economy to bring it under control. In the model for inflation that the Fed and many economists use, inflation is a function of expectations and also how much slack there is in the economy. The more you need to bring core inflation down, the more slack you need to create in the economy. It is not as simple as this, but still a useful framework.
Illustration: Binay Sinha
If one assumes that 150-200 basis points of the inflation gap is cyclical, you may need the Federal Reserve to slow the economy by a lot more than investors realise. I have seen various modelling on this by sell-side Wall Street banks and many imply that we may need to see unemployment rise by as much as 400 basis points before enough slack is created to bring cyclical inflation down by 150-200 basis points. This would be a shock to markets as the only way unemployment in the US can rise by this magnitude is through a recession. A recession would decimate corporate profits and definitely bring markets down further. Thus to what extent today’s inflation surge is cyclical, rather than temporary Covid-related and the extent of slack needed to bring inflation under control are critical decision variables for any investor.
A related point is the constraint on the Federal Reserve’s tightening agenda due to debt dynamics. The last time US inflation was at 7.5 per cent was in 1978. Back then Federal debt/gross domestic product was at only 32 per cent, and in no way a constraint on Paul Volcker tightening monetary policy to eventually crush inflation.
Today the same numbers are over 130 per cent, without even counting the social security mess. The federal government debt is at $30 trillion. Even 150 basis points rise in yields across the curve, which is not implausible if inflation is truly sticky, will imply an additional $450 billion in interest cost over time as the existing stock of debt redeems. The US has a current tax base of approximately $2 trillion. Can they afford an incremental 20 per cent of revenues going towards debt service without falling into a debt trap? This is before we even come to the effects on the broader economy and consumption. Record low interest rates have hidden many cracks in both consumer and corporate balance sheets. Many economists feel the US economy will stall if rates rise by 150 basis points across the curve.
Inflation is a real worry. There remain two camps, those who think this is largely transitory and inflation is close to peaking and those who feel the Fed was too complacent and has dropped the ball and now needs to raise rates quickly and aggressively. Both sides make compelling arguments. I only hope the transitory camp is right as the markets can fall a lot more if we are in for a sustained inflation battle. Most investors who are active today have never seen sustained and high inflation. Even now fixed income markets do not expect inflation to remain elevated beyond 12-18 months. If these expectations are wrong and rates rise higher and for longer than currently expected it is not clear where the dead bodies will surface. This could be the beginning of a regime change. Regime change implies that correlations break down and valuations get reset, it will have a huge impact on currencies, gold and emerging market assets beyond just equities and bonds. We are in for a very bumpy ride if inflation is truly breaking out.
The writer is with Amansa Capital
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