Commentary on Political Economy

Tuesday 13 July 2021


Another surge in US inflation doesn’t faze markets

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If the spike in US inflation this year was supposed to be transitory, as the US Federal Reserve Board has consistently claimed, it is turning out to be quite a prolonged transition.

The headline inflation number for June was expected to come in around 5 per cent higher than a year earlier, or a fraction lower. Instead it was 5.4 per cent, continuing a trend of surging inflation this year.

So far this year the one-month inflation rate has climbed 0.3 per cents in January, 0.4 per cent in February, 0.6 per cent in March and 0.8 per cent in April. It dipped to 0.6 per cent in May before bouncing to 0.9 per cent last month to post another 13-year high. On the Fed’s preferred measure, core inflation (excluding food and energy) rose from 3.8 per cent in May to 4.5 per cent – its biggest rise since 1991.

The “transitory” inflation in the US is turning into quite a prolonged transition.

The “transitory” inflation in the US is turning into quite a prolonged transition.CREDIT:GETTY IMAGES

With the “base effects” - comparisons with the pandemic-depressed months last year – now fading, the latest numbers will encourage critics of the Fed’s position that the spike in inflation is a passing and fleeting post-pandemic phenomenon, although there is no expectation yet that the Fed will alter its stance.

That may, of course, change if the numbers remain elevated through the September quarter where those base effects will essentially have been washed out of the comparisons.

There is an increasing focus in the US on what the Fed chairman Jerome Powell might say at the annual meeting of central bankers and economists at Jackson Hole in Wyoming in August.

If there is to be a change of stance – if the Fed is to start “tapering” its $US120 billion ($161 billion) a month of bond and mortgage purchases and bring forward a rate rise from the earliest expected moment in 2023 -- that would be the obvious venue to announce it.

For the moment, the Fed can continue to argue that the elevated inflation rate is a transitory product of the pandemic. It can cite some peculiarities in the numbers – a 45 per cent increase in used car prices, for instance – to support its view that the surge is transitory.

Used car prices have soared because of a shortage of new cars, partly due to the global shortage of semi-conductors. Oil prices, $US43 a barrel a year ago and about $US52 a barrel at the start of this year, have risen to more than $US76 a barrel, also contributing to the headline inflation rate.

It could also be that the inflation numbers reflect the massive doses of stimulus the Trump and Biden administrations have poured into the economy over the past year. Whether that stimulus has a temporary or more long-lasting effect might hinge on whether Joe Biden can get some more, very ambitious, spending programs through Congress.

Even excluding those influences, however, there does appear to be an across-the-board rise in underlying inflation.

As the worst impact of the pandemic in the June quarter last year continues to wash out of the numbers, a clearer picture of a more settled future and of the likely strategies of central banks and governments should emerge.

Some of that may be related to continuing supply chain disruptions and strains but it is also possible that demand patterns have changed as a result of the pandemic, and also that businesses are raising prices to make up for lost earnings during the worst of its impact last year.

It is conceivable, therefore, that some of the inputs into the higher inflation rates are being baked in, along with self-fulfilling expectations of increased inflation among consumers and businesses. Commentary from the senior executives of Americas’ larger companies suggests that companies are raising prices to recover their higher input costs.

Inflationary pressures not seen in decades aren’t just an American phenomenon, but are surfacing around the globe from China to Europe.

Contributing factors, beyond the distortion and change wrought by the pandemic, could be the permanent changes to global supply chains as countries re-shore activities the pandemic has exposed as essential, like medicines and personal protective equipment, and perhaps the impact of the accelerating de-linking of the American and Chinese economies begin to emerge.

It was curious and notable that even though the inflation data came in well above expectations, the financial markets digested them quite comfortably.

Stocks were down modestly (the S&P 500 fell 0.35 per cent) and 10-year bond yields edged up slightly but, at 1.41 per cent, remain well below their year-highs in late March of around 1.75 per cent.

The steep fall in long bond yields since March – when the concern about the rising inflation rate was most evident – signals that bond investors have bought into the Fed’s view of inflation being transitory.

In real, inflation-adjusted, terms the entire US yield curve is solidly in negative territory, which suggests investors are far more concerned about US economic growth fading than they are about the risk of sustained inflation above the Fed’s 2 per cent target.

There are signs, in China (which was first into the pandemic and first out, and which therefore provides some sort of exemplar) and elsewhere, that as the stimulus wears off economies could slow quite rapidly in a post-pandemic environment that is quite different to that which pre-dated it, and which still faces considerable risks from virus mutations like the Delta variant despite the steady rise in vaccination rates in most advanced economies.

What that post-pandemic future might look like is critical for governments that have gorged on debt to fund their relief programs and for businesses, households and financial and real property markets.

Low interest rates and continuing central bank quantitative easing programs make debt-servicing more affordable while validating and underwriting soaring house prices and equity valuations that would appear stretched to breaking point by historical standards.

The data from prices, economic activity and markets continues to remain confused, but as the worst impact of the pandemic in the June quarter last year continues to wash out of the numbers – as the base effects disappear – a clearer picture of a more settled future and of the likely strategies of central banks and governments should emerge.

For the moment, most market participant and analysts - and the Fed - are quite sanguine about what that might look like. They could, of course, be wrong.

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