In focus: U.S. inflationary forces

Framed as a subtle shift in policy, U.S. Federal Reserve (Fed) Chair Jerome Powell recently announced an important, if widely expected, shift in the way it thinks about employment, inflation, and interest rates—with far-reaching implications for investors.
  

When the Fed announced its decision to move toward “a flexible form of average inflation targeting,” effectively confirming the central bank’s desire to overshoot its official 2% inflation target,¹ the markets barely budged. However, it wouldn’t be wise to mistake Wall Street’s subdued response for disinterest—it’s an announcement that’s very relevant to investors, particularly those interested in inflation dynamics, specifically, upside surprises to inflation over the next three to six months. In our view, a structurally dovish Fed combined with stronger inflation data ahead effectively moves inflation expectations higher and moves real rates lower.

The inflation versus deflation discussion isn’t necessarily binary in nature; it’s filled with nuance, counterforces, and a number of unknowns. In truth, inflationary and deflationary pressures are at play simultaneously and as these opposing forces fluctuate, investors will likely go through periods during which they worry about deflation and other periods during which they’ll fret about inflation. These are important investment considerations with different implications that could lead to different investment outcomes. In our view, there are four key ideas that are central to any debate about inflation. 

Framing the inflation debate: four key ideas

1. Timelines matter
   
   We believe that a great deal of confusion surrounding the U.S. inflation outlook can be traced to difficulties in delineating the near-term inflation trajectory from its long-term path. There are inflationary and deflationary forces in every time horizon, but one will inevitably outweigh the other at different moments. 
   
   
2. Market expectations
   
   It isn’t just the level of inflation that markets care about: The type of inflation that’s being generated (cost push versus demand pull) and the extent to which it deviates from expectations are just as important. It’s also worth noting that what’s considered unacceptably high inflation to one person can be different to another—for instance, millennials and Generation Z have never seen 3% inflation in their lifetime. Critically, it’s important to recognize that mild to moderate inflation needn’t be strictly negative for equities.
   
   
3. Regime shifts 
   
   

   We may be in the midst of a structural regime shift in terms of the drivers of inflation. We expect future inflation to be driven more by active fiscal policy and deglobalization, and less by monetary policy. Classic inflation models are therefore far less relevant and shouldn’t be used to predict future inflationary pressures. This suggests old-school correlations, such as the Phillips curve, might not be as useful as they once were. And remember, economists generally don’t have a good track record at predicting (or understanding) inflation.

    

4. Measurement issues 
   
   

   It’s also important to note that classic CPI measures weren’t able to accurately measure the cost of living in the United States for some time now—it isn’t a new issue and we believe it’s likely to be even less accurate now. Policymakers are increasingly looking to address this problem, and it’s likely that both formal and informal measurements of inflation will need to be adjusted in the coming years, particularly with respect to housing costs and asset prices, which would likely push measured inflation higher.

10 near-term price pressures (next three to six months)

Given that the United States is in the middle of a pronounced recession, the idea of rising inflationary pressure within the next three to six months might seem counterintuitive. Shouldn’t a recession lead to demand deflation typically associated with large output gaps? In theory, yes, but the current economic shock is fundamentally different from a regular recession, and we see 10 key near-term inflationary pressures that are likely to contribute to inflation moving quickly back to 2% or above before year end. Given the economy’s weak growth profile, we think it’s more accurate to characterize this tactical period as stagflation.

1. Although the United States and most economies worldwide are experiencing a massive demand shock, most data suggests that demand is coming back more quickly than supply. Unlike previous recessions, we expect the supply shock to be both more persistent and more painful. This is a scenario that’s fundamentally inflationary, although there’s a lid on how high inflation can rise when the output gap remains open and demand is still quite weak.
   
2. The Fed’s shift toward average inflation targeting should help to keep inflation expectations much closer to 2%, potentially putting a floor under how far prices can fall. In addition, the Fed (and most economists) have long believed that inflation expectations themselves play a role in future actual inflation.²
3. We expect U.S. consumers to deploy the sizable buildup in personal savings accrued over the past few months—a result of government support such as stimulus checks and unemployment insurance top-ups. This is likely to increase money velocity temporarily.
4. Disrupted supply chains and a reduction in trade activity have contributed to reduced supply, but inventory shortages in several core products have exacerbated the impact. We expect this to persist until business confidence revs up in 2021. Until then, cost-push inflation is likely to materialize, presenting a new challenge for the U.S. economy. Tariffs on imports introduced over the last few years will also likely support price rises.
5. Prices for key components in the CPI basket such as air transit, hotels, and apparel bottomed in July,3 which suggests the initially deflationary impact of the pandemic is now fading and is no longer directly contributing to negative month-over-month inflation prints.
6. Commodity prices have risen sharply, including lumber, copper, and iron ore, over the past four months. Oil prices are no longer declining in year-over-year terms.
7. The U.S. dollar has weakened ~7% since its peak in March.³ It’s a development that’s supportive of U.S. inflation, with a small lag.
8. We’re seeing evidence that labor costs are rising, both through the need for top-up pay for essential workers and higher wages to lure workers back into work. While this is likely the most transitory of inflationary pressures, we believe investors should also factor in the possibility of a higher federal minimum wage in the next year. 
9. We expect corporates to enjoy higher pricing power in an environment of reduced supply—this is particularly true for the goods sector, although the effect may not be uniform across all sectors. Put differently, the rising costs of inputs like intermediary goods and labor can be passed on, at least in part, to end consumers.
10. We expect shelter costs to rise as U.S. housing continues to perform well thanks to low rates. There is also a general consensus that housing inflation in the United States might be under calculated in the CPI and statistical bureaus have discussed improving the calculation. It’s worth noting that shelter accounts for 34% of the CPI basket.