Will inflation start to behave?

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As investors, we’re bombarded with information and it’s often hard to see the wood for the trees. In particularly chaotic times, I force myself to look through the noise and consider what the most critical question is for me right now.

Today, that question is ‘will inflation start to behave?’

Inflation certainly didn’t behave last year. We came into 2022 with a brewing inflation problem but central banks assumed that it would prove to be transitory, fading as pandemic related supply chain issues eased. They didn’t believe higher inflation warranted higher interest rates.

However, when Russia’s invasion of Ukraine sent commodity prices soaring, it became clear the central banks had a much bigger and more persistent inflation problem on their hands. Headline inflation pushed higher and with unemployment low, workers were confident enough to ask for higher pay. The risk of a 1970s style wage-price spiral forced a major rethink for policymakers. They had no choice but to raise interest rates and weaken the economy, conceding that rising unemployment and a recession were necessary evils to restore price stability. This led to the turmoil in stock and bond markets that we saw last year.

The economy is now slowing in reaction to those higher interest rates. New housing market activity has softened notably, particularly in the US. Consumer demand has slowed. The latest PMI (Purchasing Managers’ Index) data – the key indicator of economic activity – suggests activity is either stagnating or contracting moderately in all major Western regions.???

If we soon get signs that this moderation in activity is weighing on inflation then central banks can feel confident that they have regained control and can stop hiking interest rates. In which case, I’m fairly confident that the recession will be moderate. Bond yields should stabilise, while stock investors will likely look through near-term weakness in earnings and towards the recovery of 2024.

If, however, inflation proves sticky, there is a much greater risk that last year’s sell-off in stocks and bonds repeats itself. Central bankers would have to keep their foot on the brakes, forcing a deeper recession.

So that’s why I think this is the important question. Now what’s the answer?

In a nutshell, I believe inflation will start to behave. To understand why, there are three buckets of inflation we should consider; energy, goods and services.

Energy currently contributes 0.5 percentage points (pp) to US inflation, 1.7pp to eurozone and 3.1pp [1] to UK. If energy prices stabilise, this contribution should drop out over the coming months, but the risks are evenly balanced. Energy could start to detract from inflation if the recent decline in wholesale gas prices is sustained. However, we need to keep an eye on whether China’s reopening boosts oil and other commodity prices. We don’t think it will, but it’s a risk worth monitoring.

Goods price inflation should also fade. Pandemic issues are easing, freight costs have fallen and fewer firms are reporting long supply chain delays.

The trickier components are the domestically-generated segments, such as services. Costs and inflation in these sectors are strongly influenced by the labour market, which is still very tight with vacancies elevated relative to the number of unemployed.?

As demand fades, firms are likely to stop advertising for new staff and some may even resort to redundancies. It’s possible that vacancies falling back will be enough to bring down wage growth as workers are no longer being lured into new jobs through higher pay. There is some tentative evidence of this already happening in the US, and we expect it to also be the case in Europe over the coming months.

So overall, I do expect inflation to start behaving in 2023. But there are risks. I’ll be keeping an eye on Chinese demand for commodities, wholesale gas prices, job vacancies and wage growth to check that view is on track.?

[1] Source: BLS, Eurostat, ONS, J.P. Morgan Asset Management.?

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