The Global Inflation War

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Normally, the great challenge in talking about the global economy is finding a theme.?The economic fortunes of nations are usually driven by such a disparate array of political, financial, demographic and environmental cross-currents that it is impossible to establish a framework for analysis.?Twice however, in this still young century, events have unfolded to provide just such a theme as the world battled the global financial crisis in 2008 and the global pandemic in 2020.

In 2022, there is also a unifying theme – higher inflation across almost all major economies.?However, even here there are significant differences in the degree of inflation that countries face, the underlying causes of the inflation, prospects for inflation going forward and the steps central banks are willing to take to combat it.?As summer winds down and investors need a quick update on the global financial environment, one convenient short-cut is simply to look at the war on inflation across the United States, the Eurozone, the United Kingdom, China and Japan.

The United States: An Inflation Cold Front Moves Through

In the U.S., last week finally brought distinctly better news on inflation.?In July, on a month-over-month basis, headline CPI was unchanged, producer prices fell 0.5% and import prices declined 1.4%.?However, on a year-over-year basis, that still leaves CPI up 8.5%.

8.5% year-over-year is, of course, better than the 9.0% gain posted in June.?However, it is still higher than in any month in the forty years between 1981 and 2022.?There is no doubt that part of the U.S. inflation problem, as elsewhere in the world, stems from the supply disruptions of the pandemic.?However, aggressive fiscal policy also played a role as the federal government boosted the budget deficit from an already very high 4.7% of GDP in fiscal 2019 to 15.0% in 2020 and 12.4% in 2021.?Importantly, the majority of this fiscal stimulus was aimed at middle and lower-income households, who responded, unsurprisingly, by sharply increasing their consumption of goods.

In addition, years of very easy money from the Federal Reserve, while not generating much of a boom in home-building, did contribute to a boom in home prices.?These higher home prices feed (with a lag), into both actual rent and owners’ equivalent rent which, combined, account for over 30% of headline CPI.?Finally, in February 2020, just before the pandemic started, the U.S. unemployment rate fell to 3.5%, its lowest rate since 1969.?This had already led to a gradual increase in wage gains from less than 2.0% year-over-year in 2012 to over 3.0% in 2019.?With labor force growth slowing due to the retirement of the baby boom and a sharp drop in immigration, wage growth was primed to accelerate as the economy recovered from pandemic shutdowns.?

Finally, even with all of these pressures, inflation might have peaked earlier in 2022 had it not been for the impact of Russia’s invasion of Ukraine on global energy and food prices and the disruptive effects of China’s attempts to suppress the Coronavirus.?

Having said all of this, there is a good chance that U.S. inflation has now peaked.?Gasoline prices have fallen on a daily basis for two months while airline fares, hotel rates and used car prices are also falling.?In the medium term, despite a strong July jobs report, the U.S. economy has clearly lost momentum with real GDP declining in both the first and second quarters.?A continued drop off in fiscal stimulus, despite the passage of some key legislation recently, will also tend to depress growth and inflation as will the impact of high dollar on trade and the effect of higher mortgage rates on housing, (which should be visible in this week’s Housing Starts and Existing Home Sales reports).

At his last press conference, following the Fed’s July 26th/27th FOMC meeting, Chairman Jerome Powell acknowledged that the last two 0.75% Fed rate hikes were aggressive but that the Fed would be data dependent and could be equally aggressive at their September meeting, if the data warranted it.?

The crucial point, of course, it that it looks like the data won’t warrant it and, as of now, we expect the Federal Reserve to raise rates by 0.5% in September, 0.25% in November and 0.25% in December, leaving the federal funds rate at between 3.25% and 3.50% and holding at the end of the year.

The Euro Zone: Still Waiting for an Inflation Peak.

While there are strong signs that inflation has peaked in the United States, the story is less clear in the Euro Zone.?In particular, consumer prices registered an 8.9% year-over-year increase in the flash estimate for July compared to 8.6% for June.?While the Euro Zone was more successful that the U.S. in limiting the spike in unemployment during the pandemic, they achieved this with less fiscal stimulus, limiting both the pace of economic recovery and the feed through to lower unemployment and higher inflation.?By the first quarter, employment costs were up a moderate 3.8% year-over-year (compared to 4.5% in the U.S.) and the unemployment rate, while low by European standards at 6.6% in June, was still far above the 3.6% seen in the U.S.

However, Europe is now facing other inflationary challenges.?The most obvious problem is the Ukraine war which boosted energy prices by almost 40% year-over-year in July and which threatens to cause more disruption this winter as Russian gas supplies dwindle.?In addition, Europe has faced the unwelcome effects of a strong dollar with the Euro/USD exchange rate falling from $1.23 at the start of 2021 to $1.03 today.?This has exacerbated the commodity price surge for European consumers as global commodities are generally priced in dollars.

Going forward, barring a sudden collapse in the U.S. dollar or a ceasefire in Ukraine,?it is possible that inflation will remain more stubborn in the Euro Zone than in the U.S.?However, it is still likely to drift down in the year ahead with slower economic growth, monetary tightening and a loosening of supply constraints.

In July, the European Central Bank announced a 0.5% increase in its deposit rate, bringing it back to zero and signaled that there would likely be a further increase at their next meeting on September 8th.?While the ECB cannot impact most of the factors that have led to higher European inflation, continued rate hikes, in an environment where the Federal Reserve begins to take a more dovish stance, could lead to an appreciation of the Euro, combatting at least one source of Eurozone inflation.?

At her press conference at the end of the ECB Governing Council meeting on July 21st, the President of the ECB, Christine Laguarde reinforced the messaged that the ECB’s policy will continue to be data-dependent and would help them deliver on their target of 2% inflation in the medium term.?In contrast to the Federal Reserve, these data may well justify no relaxation in the ECB’s recently more hawkish stance between now and the end of the year.

United Kingdom: No Easy Choices

The UK is, if anything, facing a more daunting inflation challenge than the United States or the Eurozone.?CPI inflation was 9.4% in June and this Wednesday’s retail price report should reveal an even sharper increase in July.?Moreover, because of the lagged effect of higher natural gas prices on consumer utility bills, the Bank of England is currently forecasting that inflation will peak at over 13% in the fourth quarter of this year.?

UK inflation, like that in the Euro Zone has been boosted by higher energy prices.?However, labor market statistics are tighter in the UK with a 3.6% unemployment rate in May (which may have fallen further in June) and a 6.2% year-over-year increase in wages.?Sterling, like the Euro, has fallen sharply over the past year relative to the dollar, contributing to higher imported inflation.?

The inflation outlook in the UK is further complicated by the current Conservative Party leadership race with both candidates promising fiscal stimulus to shield consumers from the negative income effects of higher utility bills.?This extra deficit spending should reduce the risk of a five-quarter recession projected by the Bank of England under current fiscal policies.?However, it would further worsen the public finances in the U.K. and could pressure the Bank of England into more aggressive tightening.

In early August, the Bank of England increased Bank Rate by 0.50% to 1.75% in a sixth consecutive rate hike and suggested that a further rate hike, of perhaps the same magnitude, could be on the cards for its mid-September meeting.?Unlike the Fed or the ECB, it looks like the Bank of England may have to combat an expansionary fiscal policy in its attempts to get inflation back to its 2% target.?Moreover, as it made clear in its August Monetary Policy report, it is determined to achieve this goal, even if it means putting the UK into recession.?As Andrew Bailey, the Governor of the Bank of England stated at his August 4th press conference, there are “no ifs or buts in our commitment to the 2% target”.

China:?Problems beyond Inflation?

China’s inflation rate, in contrast to Europe and the United States, remains relatively tame.?Consumer prices rose 2.7% year-over-year in July, up from 2.5% year-over-year in June, while producer prices backed off to 4.2% year-over-year compared to 6.1% in June.?The yuan has fallen by roughly 6% relative to the U.S. dollar since March.?However, this largely reflects the global appreciation of the dollar – on a trade-weighted basis the Chinese currency has been relatively stable year-to-date.

Inflation in China will likely remain relatively subdued in the near term largely because of significant pressures slowing demand.?While the government has signaled some modification of its zero-Covid policies, attempts to prevent a major Omicron outbreak will likely continue to hamper economic growth.?The housing sector continues to struggle with major over-supply, falling prices and developer debt.?This not only directly impacts housing activity but it has knock-on effects on consumer financial positions, local government funding and supplier industries.?In addition, China’s huge export industries are being threatened by a global slowdown.

All of these issues are having an impact on economic activity and Chinese authorities are downplaying their goal of 5.5% real GDP growth for 2022, which now looks unattainable.?Indeed, just this morning, the National Bureau of Statistics released weaker-than-expected data on retail sales, fixed investment and industrial production.?Just before the release of these data, the PBOC announced a 0.10% reduction in its one-year medium term lending facilities and seven-day reverse repo rate, and monetary easing, rather than monetary tightening looks more likely in the year ahead.

Japan: A Welcome Rise in Inflation

Japanese inflation remained moderate in June with overall CPI rising by 2.4% year-over-year and core inflation, excluding food and energy climbing just 0.2% relative to a year ago.?July CPI inflation, due out Friday, is expected to fall to 2.2% year-over-year with a slight uptick in core inflation to 0.4% year-over-year.

Although inflation is now above pre-pandemic levels in Japan, it remains low in absolute terms.?This is despite a collapse in the exchange rate, which has seen the yen fall from 105 to the dollar in early 2021 to 133 today, the same supply disruptions that have boosted inflation elsewhere in the world and significant fiscal stimulus.?

However, deflationary psychology is deeply imbedded in Japan as the Bank of Japan has failed for many years to achieve its sustained 2% inflation target.?Even with inflation running above that target over the summer, at its July meeting the Bank of Japan predicted a relapse in inflation to 1.4% in fiscal 2023 (which starts in April of next year).

This prediction of low Japanese inflation is probably on the mark.?While the Japanese economy saw 2.2% real GDP growth in the second quarter, growth will likely slow in the third quarter as a wave of Omicron infections appears to be generating weakness in both manufacturing output and services demand.?Signs that the Federal Reserve may move in a more dovish direction appear to have halted the yen slide, while weakness in the Chinese economy should further stem demand.

Wage growth has picked up recently in Japan and this, along with a still very low unemployment rate of 2.6% should allow Japan to avoid a return to outright deflation.?However, in a world where many countries see high inflation as a problem, Japan would welcome a period where inflation was steadily positive.??

Investment Implications

For investors, while global inflation has been the key theme of the first half of 2022, inflation should generally fall over the rest of the year and into 2023.?Some key central banks, however, including the Federal Reserve, the European Central Bank and the Bank of England, sound very determined to help cut inflation faster.?They may succeed, but only at the cost of generating further economic weakness or recession.

Having said this, even if central banks overdo it, the global economy should return to an environment of slow and steady growth in 2023 and beyond, with much lower inflation than has been seen this year and, eventually, lower interest rates.?Both long-term bonds and global stocks should benefit from this trend, although market volatility, as the inflation battle rages, will likely continue to favor those financial assets that currently look most attractive from a valuation perspective.?

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