Once inflation falls, at what level will it settle?

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In a bid to cut through the noise, I ask myself each month what is the key question I need to focus on? Last month I argued that key question was ‘Will inflation start to behave?’.

The volatility of the last few weeks demonstrates why this question was and remains critical. The market’s prevailing answer to this question has swung wildly. Back in October, investors were fixated on the prospect of a re-run of the 1970s; out of control inflation that would require a deep recession to tame it.

That view switched to something remarkably more benign earlier in February, with hopes of a return to a Goldilocks economy. Optimism about a peak in wage growth and potential shelter disinflation gave rise to the hope that inflation would fall so quickly that the Federal Reserve might not need to tighten much at all and could even cut rates to ensure a soft landing. Both stocks and bonds rallied strongly at the start of February.

However, January’s US inflation reading – which was stronger than expected –upset this narrative and bonds have since given up their gains. The inflation rollercoaster continues.

My central expectation is still that inflation will gradually ease and alongside some moderation in wage growth, central banks will be increasingly comfortable that the era of double digit inflation is well behind us.

The question I am now turning to is ‘Once inflation falls, at what level will it settle?’. The inflation level is important for investors because it will determine whether we are going back to an era of low inflation and, therefore, low bond yields. This in turn would influence equity performance since some segments of the market (e.g. tech) thrive on low interest rates, while others (e.g. financials) do not.

I believe we are in a new, structurally higher inflation environment. 3% is the new 2%.

There are many reasons for this. Goods price deflation is not likely to be as prevalent as it was in the past. The basket of non-energy goods that the UK consumer bought in 1990 was outright cheaper thirty years later.?

I simply can’t see history repeating itself. Globalisation may not go into reverse but it is unlikely to be the disinflationary force it once was. Bringing in the costs of externalities such as environmental damage to consumer pricing is also likely to result in upward pressure on prices.

What I am indirectly arguing is that central banks will be more willing to miss their inflation target.

Ultimately, I believe this upward shift in the level of inflation will be not only accepted but welcomed. This is because a 3% inflation target would, other things being equal, lift the average nominal interest rate by 1 percentage point.

The new, higher inflation target would reduce the likelihood of interest rates hitting the zero bound and central banks having to resort to unconventional policy tools like quantitative easing. In my opinion, it is now abundantly clear that quantitative easing is not a substitute for conventional monetary policy. It entangles the central bank with the government in a way that potentially risks its independence, or at least the perception of its ability to act independently.

Of course, this is not a debate central bankers will engage in for some time for fear of being perceived as going soft on inflation, but it’s where I believe we will ultimately land.

For investors, the key is to avoid being anchored to the past low interest rate, low bond yield cycle. 4% on the US 10-year Treasury bond might not be an unsustainable ‘high’ rate. For equities, one may expect the rotation away from the parts of the growth segment that had thrived in the low interest rate environment, to the value segment that had languished to continue.?

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