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Temporary worries often linger longer than expected. And this is the case with inflation. Although the Fed and ECB continue to refer to it as “transitory”, it is increasingly playing on the minds of investors, producers and consumers. Even some Fed members are starting to get agitated about it. Minutes from their last meeting are evidence of this, with an increasing number believing that the benefits of current liquidity injections into the system are beginning to be offset by the negative impacts, namely inflation.
But central banks cannot influence all types of inflation, even if they all include its management as part of their mission. The situation is not clear-cut.
Firstly, reflation is not inflation. The former refers to a rebound in prices from a level considered excessively low. One example of this is the current oil price. Over 10 or even 20 years, the average price per barrel for Brent crude has been USD 70 in today’s dollars, which means this average would be higher if inflation were included. Today’s oil price is hitting peaks not seen since 2014, of over USD 80. But if we take a step back, current prices represent a return to close to the average, after incredibly low prices in 2020 and a generally depressed level for the last five years. This reflation indicates the return to some equilibrium. A central bank should not worry about this. And anyway, it cannot influence it.
The situation on other energy markets, such as gas and coal, corresponds more to real inflation, and is pushing up the cost of heating, electricity and, ultimately, manufactured goods. But central banks can do nothing about this. In broader terms, inflation in the price of goods where demand outstrips supply due to temporary reasons is also outside of the remit of central banks. This is currently the case with the price of electronic chips and, due to a knock-on effect, some durable goods. Supply generally ends up matching demand, or even exceeding it and causing a deflationary counter-shock that is also temporary. Central banks have no cure for this.
However, central banks do have responsibility for long-term inflation in the economic system; specifically, in financial and real estate assets, and wages. The first two create a transitory wealth effect, which may lead to excessive risk-taking that creates bubbles and crises. The latter certainly has a favourable impact on households initially, but this then turns negative when wages are spent and not saved, causing inflated prices across the board. There may be no real growth in purchasing power. And the currency will tend to devaluate, making imports more expensive.
We are starting to see this phenomenon, particularly in the US. The latest employment data illustrates this trend, with significant wage growth of 4.5% year-on-year, particularly for low-wage workers, where the increase was 7%. This would be positive if prices were not rising at the same time. But they are, especially for housing – not just for some goods where there are procurement issues, which we have already seen is not a real concern. Indeed, the “rent” component of US inflation rose 0.5% in August, its strongest monthly rise since 2001, and the “owners’ equivalent rent of residence” rose 0.4%, the highest monthly change since summer 2006! This means that what is given with one hand is partly taken away with the other.
Here is where central banks can play a role, by tightening financial conditions to cool the system, but without freezing it up. And the earlier the better, as waiting only means more severe action is required.
Undoubtedly, there will be a change in tone in forthcoming central bank statements, particularly those from the Fed. Several emerging countries, but not China, have already done this. Markets will reflect the change. The US yield curve could continue to flatten. Either overall, or particularly at the short end, which reflects expectations for monetary policy to a greater degree. The advantage today is that – with experience gained in recent tightening cycles and in light of the size of the debt – this process will be managed with extreme caution, but nonetheless with determination. The market is therefore in the expert hands of Fed Chair Jerome Powell, who will have to play on the various shades of prices to lift the economy out of the inflationary cycle on which it appears to be embarking.
Written on 15 October 2021, Author: Olivier de Berranger, CIO
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