Transitory inflation? No, it is not

Since the resurgence of inflation in March 2021, the first time the annual US Consumer Price Index (CPI) jumped above 2.5% after October 2018, there has been a heated debate on whether the inflationary spike is just temporary or we have started a new stage. This article aims to clarify where we are and what we can expect.

For starters, it is important to underline that with this debate we are just splitting hairs. As the chart above shows, prices always tend to go up over time. Whether persistent or temporary, the abnormally high inflation rate we are currently experiencing will have negatively affected our purchasing power. What really matters is that the inflation rate is now too high and is unlikely to drop dramatically in the foreseeable future. With the lack of corrective measures and their continued dovish policies, central banks fail to realize that once inflation is embedded into an economy, it can be very difficult to eliminate.

Why does then the Federal Reserve (the Fed) qualify inflation as 'transitory'?

1. Because everything is transitory in life. Nothing lasts forever (ok, taxes might be an exception) and neither do sharp rises in inflation. However, many people interpret 'transitory' as if inflation will last just a short time. That can be dead wrong because after 4 months being close to 5% or above, inflation is highly likely to remain around 50% above the Fed's target or higher, at the very least for the coming 12 months.
2. Although there are several 'red flags' pointing to a sustained high inflation (clearly above the 2% target) for more than 2 years, the Fed cannot be transparent and say loud and clear that this is the situation. That would send shivers down everyone's spine and would only accelerate pricing pressures, since it would be perceived as a fait accompli.

Andy Haldane, the now departed Bank of England chief economist, noted in June that "time and again in the past, localized price pressures turned into generalized price pressures, and those temporary spikes in prices morphed into more persistent rises in prices". After all, inflation is extremely difficult to control.

What are the most important 'red flags' pointing to a sustained high inflation?

• The record run in energy prices is not expected to end anytime soon, with energy analysts warning market nervousness is likely to persist throughout winter. Global oil demand grew a spectacular 7 MBD in the first 8 months of 2021, oil prices have soared and they are not only currently above pre-pandemic levels, but also highly likely to continue rising. Electricity bills are now the most expensive in Europe. Gas prices have skyrocketed and that has lifted coal prices to record highs too. Despite these booming prices, global energy prices cannot yet be deemed high.

• It's not only about energy. Commodity prices have grown across the board. Below you can see a chart showing the evolution of the The Refinitiv/CoreCommodity CRB Excess Return Index, which is currently made up of 19 commodities. The index shows that the bearish trend, which originated in 2008 and lasted 12 years, has been broken and commodities might have started a new supercycle. Many years of depressed prices have led to very low investment in resource discoveries, which may result in supply constraints. With pervasive resource shortages, input price pressures will continue to be widespread. Additionally, the current transition to a green economy together with the climate challenges are likely to benefit several commodities whose supply will have a difficult time meeting demand.?

• Unless prices have shown a 'hiccup' pattern in 2021 and from now on we see a clear drop that quickly reduces inflation to a level below 2% (important caveat: I have been explaining over the last quarters that this will not be the case), we must realize that many companies haven't gone yet through the process of adapting their prices to account for the increase in production costs. In fact, the last Fed’s Beige Book released in September confirms that “businesses anticipate significant hikes in their selling prices in the months ahead”, so pricing pressures will stay.

"We can all agree that the economy has not yet recovered the activity and growth levels that we used to experience before the pandemic. With regard to inflation expectations, I agree with those who think that we are unlikely to see strong inflation figures during the rest of this year. However, as we enter 2021 prices could start showing upside pressures nurtured by growing prices in commodities and the many supply bottlenecks, supply chain disruptions, and cost inflation that the transition towards deglobalization will undoubtedly bring." Carles Iborra, August 31st 2020

• The inflationary spike is already affecting wages and unless pricing pressures are subdued and step back significantly (which, again, do not expect that to happen anytime soon), the wage-price spiral will continue to be triggered, thus adding more pressure. At the same time, since the bottom 50% of the population is the most affected by higher prices, governments will be forced to figure out some aid to prevent social unrest and that should add more pricing pressures.

• Many of the supply disruptions that occurred during the outbreak of the pandemic have not been solved yet. Maritime freight rates have soared (see the chart of the Baltic Dry Index below) and these costs end up affecting the price of many goods. Some supply chains are still under pressure (e.g. semiconductor shortages are weighing down the industrial recovery) and several governments of the G7 countries, concerned by the fact that supply chains are not resilient enough, now promote reshoring in order to adapt to changing geopolitical conditions. However,?connecting the US and China economically has taken over 3 decades, resulting in a complex web of supply chains and sizable investments.?Unraveling those ties will not be easy, will have a significant cost to those affected, and will imply both a lengthy time-horizon and higher prices.

• Finally, it should be noted that the Bureau of Labor Statistics only uses rent and rent proxies to calculate the impact of the Shelter category, which accounts for 30% of the US CPI. More than three quarters of that calculation is based on a guesstimate of homeowners (i.e.: Owners’ Equivalent Rent or OER) and the rest depends on the rental price paid by tenants. OER has remained stable over time. On the other hand, home prices have been surging month-over-month breaking new records and the federal eviction moratorium that allowed hundreds of thousands of people to remain in their homes will end on October 3rd. In this context, if OER or rental prices have any correlation to reality, CPI could start being boosted by the Shelter category, which is something that has not happened since February 2020.

For the first time in many years, the Fed's indicator that estimates the probability of the PCE (the Personal Consumption Expenditures price index) to exceed 2.5% over the coming 12 months has stayed above 80% for the last 4 months. However, regardless of all of these facts, of the existing pricing pressures, and of the rapid growth seen in inflation, investors and financial markets do not seem worried by a challenge we have not faced in the last 30 years. It is as if investors are numbed by the Fed, as if they think that at some point in time in the near future inflation will magically fade away.

Unfortunately, that will not happen unless the world falls again into recession, which at present is a little far-fetched.

So why aren't investors worried by inflation?

• Investors feel confident and positive because the economy has been strongly growing after the shortest recession in US history, employment is improving, the inflation rate is no longer going higher, corporate profits have been soaring, and financial conditions remain extremely attractive. Meanwhile, the Fed keeps its benchmark interest rate near zero, it continues purchasing $80 B of Treasuries and $40 B of mortgage backed securities per month to ensure that interest rates remain low, and the stock market capitalization is reaching all-time highs. It is no wonder investors are in euphoric mood! (see below my proprietary financial confidence indicator, which monitors more than 20 relevant variables).

• Not only that, it has become self-evident since the Great Financial Crisis that one of the Fed's big priorities is not to surprise investors. Should any of its decisions send the bond or the stock market tumbling, the Fed would be forced to quickly backtrack. Therefore, except in cases of force majeure, investors think that the Fed has their back.

While everybody is discussing whether inflation is passing through or is here to stay, and whether the Fed will start tapering sooner or later as a result of that, it should be noted that there are serious reasons to be concerned about the underlying expectations regarding future earnings. With extremely tight spreads, particularly in high-yield debt (most investors forgot why they are called 'junk bonds'), so many stock market valuations looking a bit too demanding, and when everyone is increasingly?feeling worse about the current situation because it remains unclear where growth will come from (considering expected federal spending cuts and higher taxation), it appears that there are several challenges ahead for financial markets and investors should reduce their risk exposure. Many investors do not realize we have been living in 'La La Land' and we could be heading for a rude awakening due to the fact that the current central bank policies may end up doing more harm than good.

For the first time in more than 30 years, we will experience a sustained inflation rate close to 4% or above during 2 years (the first one is already behind us) and there are many solid reasons to believe that we will be above the Fed's inflation target (2%) for even longer than that. This is not 'transitory (short-term) inflation', this is an inflation overshoot, and it has been the result of the Fed not easing off on the accelerator pedal at the appropriate time. To me, persistent high inflation coupled with slowing growth will lead to 'stagflation' (I first mentioned this word in June). In the long term, however, deflationary pressures will be back because the underlying trends continue in place (e.g. aging population, technological innovation and productivity, debt overhang and its diminishing returns...)

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Carles Iborra has worked more than 15 years in the wealth management business and is the founder and CEO of IIR, an investment research firm. He is also a Partner at Dextra International, a leading advisor in the crop protection business, and worked previously as the Managing Director of a foreign Family Office and as a Project Leader at The Boston Consulting Group, helping large corporations to boost growth and improve profitability. He has broad experience in wealth management, financial markets, and strategic management.