2 days ago · 3:15 mins
Investors have recently been betting that inflation has finally peaked, meaning that the Federal Reserve (the Fed) will be able to scale back its interest rate hikes soon – a move that would boost the economy and riskier assets like stocks. But that may be an overly optimistic view: while there are encouraging signs that inflation is easing, other signs suggest we’re going to be dealing with this for a while…
The economy is already cooling off. The Atlanta Fed’s GDPNow model – which attempts to track economic activity in real time – estimates that the U.S. economy shrank by 1.6% in the second quarter, suggesting the economy may already be in a recession. The labor market is still strong, sure, but as we explained here, that’s usually the last domino to fall. So if the economy’s already cooling, that means demand is already slowing and inflation should start to ease soon.
Supply chain disruptions are dwindling. Many economists argue that inflation was mostly caused by supply disruptions at a time when the Covid pandemic was shifting consumer demand from services to goods. Now demand is shifting back to services again, and there’s evidence that supply pressures are easing too– the falling cost of transporting goods, for one. And if supply can meet demand, inflation should fall.
Commodity prices have started to fall. Food and energy prices contributed significantly to higher inflation, particularly since they started from such a low baseline after global Covid lockdowns pushed them down. But now that prices have already been high for a while, the year-on-year price changes are likely to be much lower going forward, and could even turn negative if commodity prices continue to fall.
Plus, there’s the ol’ bullwhip effect. As Reda explained here, retailers may use their overloaded inventories to help push inflation down. They’ve got tons of stuff to get rid of, and they’re likely to do whatever they can – like slashing prices or giving out refunds without taking goods back – just to reduce their stockpiles. And since small changes in demand at the retail level can cause progressively bigger changes further along the supply chain – the “bullwhip effect” – inflation might slow.
And investors expect inflation to drop. Expectations matter a lot for inflation: when people believe prices will be higher tomorrow, they’ll ask for higher wages today and try to buy as much as they can before prices go up. Those things push payroll and commodity prices higher, which just exacerbates the cycle. Thankfully, the latest data showed that investors don’t expect inflation to rise as much over the next five years as they had been expecting a few weeks back. That could slow or stop the inflation cycle.
Those are five solid reasons why inflation should be headed out the door. But unfortunately, they’re not the whole story: today’s inflationary pressures have been broadening, and history shows us that inflation has a habit of being sticky. Plus, there are some wildcards out there that could create new inflationary pressures.
See, it’s not just food and energy that have driven prices higher. The closely watched consumer price index (CPI) includes a “core CPI” measure that shows how prices of things – excluding food and energy – have changed, and it’s also at a record level. In fact, more than 90% of the things it tracks (and it tracks everything) are showing an inflation rate of more than 5%. More worrying, it’s the prices of services – which are stickier than the price of goods – that have been rising the most lately. The broader the pressures, the more entrenched the inflation is likely to be.
History shows us that inflation has a habit of being sticky anyway. In the high inflation days of the 1970s, for example, it shot back up several times after falling, and lasted longer than investors expected. One reason for that: it can just take a while for inflation to work its way out of the system.
You can see that playing out now in the cost of buying or renting a home. Home prices have risen sharply since the pandemic, and that’s contributed to higher inflation by boosting economic growth. After all, the housing market is one of the powerhouses of the economy. But that’s also pushed rent prices higher. See, there’s a shortage of homes to buy and the prices of the ones available have gotten out of reach for a lot of potential buyers, so the demand is moving to the rental market. Rent prices may continue to rise for a while then, even if home prices start to drop. As the biggest component of the CPI basket (it has a weight of 32%), it may offset a fall in other components and keep inflation at a high level for a bit longer.
And there are also two major wildcards that could spark a new surge in inflation: the war in Ukraine and Covid. Food and energy prices have been heavily influenced by the war in Ukraine, and a flare-up in the conflict (or the decision by Russia to, say, cut the supply of gas ahead of winter) could send prices soaring again. Meanwhile, Covid continues replicating itself with new, distinct strains, so there’s going to be some risk that the virus disrupts supply chains again in key countries like China.
Even if inflation has peaked – and there’s a fair chance it hasn’t – it’s probably going to stay high for some time – likely higher than the market expects and surely much higher than the Fed’s 2% target. Fed officials know that if they pivot and go from hiking rates to holding them (or even lowering them) when the economy is still relatively resilient, they run the risk that the economy will heat up again and cause inflation to accelerate. So, what they’re more likely to do is wait for evidence that inflation is indeed returning close to their target. And that might take much longer than investors expect.
The only scenario where I see inflation dropping significantly is that of a harsh, demand-slashing economic recession. But that wouldn’t be a good outcome for risk assets like stocks: inflation would likely only come down after the economy slows down, leaving investors to deal with a stagflationary environment of low growth and high inflation – historically a tough environment for stocks.
In my view, there are too many unknowns and too many scenarios to take concentrated bets in one single outcome, and investors are arguably too optimistic about the best-case scenario. In this kind of environment, it makes sense to diversify across assets that would perform well in different scenarios: you might want to own commodities to protect against further inflation, stocks in case inflation eases and the economy remains resilient, and long-term US treasury bonds in case a harsh recession brings growth and inflation down.
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