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The US consumer prices index jumped strongly 5% year-on-year in May. How did markets react to this news? They calmed down in a matter of moments. Even more surprising was the movement in bond yields, which closed the day lower, rather than rising as might have been feared.
Rise in inflation unsurprising
One explanation for this is that the data was expected to show a sharp rise: the actual figure may have been lower than expected, but it wasn’t a big surprise. In addition, the base effect from the sudden recession in spring 2020 was bound to result in a high figure a year later. What’s more, excluding the volatile elements (food and energy) still results in a high rate, albeit one that is slightly lower at 3.8% – nonetheless a 30-year high. But most of all, the market has bought into the central banks’ scenario that inflation is temporary. Indeed, only certain sectors are affected at the moment, such as second-hand and rental cars and some property sectors like as warehouses. Inflation though hasn’t spread to wages. On the contrary, wages dropped by 2.8% in real terms. What could please the market more? Wages are falling whilst the economy soars!
Slowdown in wage and rental price momentum just window dressing?
Having said that, this apparent wage restraint in the US is something of an illusion: if overall wages are declining, it is partly because the less well paid are returning to the labour market. The real momentum in wages could prove better after the first wave of hiring following the reopening of the economy. Apparently modest rent rises could also prove deceptive, as they are partly due to the moratorium on evictions. These measures end in July, and prices could become much more volatile. Ultimately, even if price rises in some goods are due to temporary factors such as shortages of electronic chips or certain metals, there’s no certainty that prices will subside again rapidly, particularly as demand for metals is likely to rise with the switch to electric cars and the implementation of more stringent anti-pollution standards. Yet the market remains unconcerned by these risks.
Concrete figures instead of forecasts: Central banks with a new stance
It is therefore logical that central banks may continue to pour liquidity into the market even whilst raising the prospect of inflation – in theory, a contradictory attitude. However, this is what the European Central Bank just did at its meeting on 10 June: its 2021 eurozone inflation estimate had already been increased to 1.0%-1.5% at its March meeting, and was increased further to 1.9%, i.e. up to its ideal level. But in the longer term, the ECB continues to think that inflation will be too low, forecasting 1.4% for 2023. This justifies its current action. Central banks have even changed their attitude to economic forecasts. They are now waiting to see evidence of momentum in inflation (and employment in the Fed’s case) over a certain period rather than relying on projections. This is prudent from a certain standpoint: acting on the basis of projections, which are uncertain by nature, means running the risk of being wrong. Yet, taken further, we believe this is irresponsible as central banks risk being systematically behind the cycle. And in any case, they should always be asking themselves whether the trends noted are sustainable or not. Uncertainty is inescapable. Action is risky. Not wanting to take any risks is equally so.
We’ll know how things stand in a few months. Central banks, and the markets following their lead, will either have been astute or naive. In any case, central banks will use force and dexterity to maintain favourable financial conditions that will not damage the economy. The future is thus not certain for the stock market, but at least it’s in safe hands. Like burning Rome in Nero’s hands?
With Olivier de Berranger, CIO, LFDE