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US inflation surge set to stay, warns Peter Spiller

03 August 2021

CG Asset Management’s Peter Spiller explains why investors should be sceptical of the view that higher inflation is just a ‘transitory’ event.

By Peter Spiller,

CG Asset Management

In the 1970s, unlucky Federal Reserve staffers had to inform the chairman Arthur Burns of each month’s CPI increase. When asked why the numbers were so bad, they would respond that, as it might be, bananas had doubled in price. Burns would shout “take them out of the index”.

By the end of his time in office, 65% of the index had been thus removed. There sometimes are echoes of that approach in the assertion that the current surge in inflation is ‘transitory’.

And it is certainly correct that the make-up of the recent rise in CPI in the US in particular is narrow. Most of the large increases have been in durable goods, notably in cars, and energy.

But the converse is also true, sectors like healthcare and education have been weak, suggesting that they also are subject to mean reversion. More importantly ‘owners’ equivalent rent’ at a 2.3% y-o-y increase contrasts with a rise in house prices of 23% over the period. With a weighting of 24%, that looks like a pent-up boost for the CPI.

Part of the background to the rapid increase in the price of goods and indeed commodities in recent months has been the shift in spending in both the US and the UK away from services towards durable goods and that will be reversed as economies normalise. So the demand side will reduce quite soon.

On the supply side, the timescale for response varies. Lumber in the US has already come full circle and semi-conductors may see a better balance within a year. New mines, by contrast, can take a number of years and face significant ESG hurdles.

Nevertheless, it does seem likely that as base effects wither and some ‘re-opening’ inflation, such as used cars, is partially reversed, that the CPI will reduce in the autumn and is pretty well certain to be lower than the 5% recorded for May. Much depends on the extent to which the $5trn of excess savings in consumer accounts gets spent.

More significant for the longer term is the extent to which wages rise in response to both an improving economy and higher prices. Companies like Unilever have tolerated margin pressure as a result of higher commodity costs because they feel unable to raise prices; that makes them resistant to wage hikes.

But it can also change if inflation expectations change. Certainly, the conditions that in the past have signalled wage inflation are flashing at least amber. The ‘quit’ rate in the US is at record levels. The output gap, in the view of the Congressional Budget Office will move positive by the end of this year and by this measure the economy will be running at a level as hot as it gets by the third quarter of next year. And that would take into account the returning workers as unemployment subsidies come to an end.

In the UK, the output gap is larger, but the distortions in the labour market caused by Brexit are profound and the political pressures on public sector wages are powerful. All in all, wages will be rising in both countries.

The Federal Reserve persists in regarding the current increase in the CPI as ‘transitory’ partly because they believe it and partly because they wish to ‘frame’ wage negotiations.

The surprise is the extent to which the market has accepted the forecast. In a world where economists cannot forecast the change in the CPI for the month just past within 0.5%, it seems foolish to assess the coming months and years with any precision.

Given the asymmetric monetary policy response and the fiscal stimulus, combined with a less favourable deteriorating demographic and globalisation background, the range of outcomes is quite large.

But the markets assessments, as expressed by breakevens, looks like the bottom of the range. It seems more likely to us that any autumn disinflation will prove transitory and that elevated inflation is here to stay.

Peter Spiller is manager of Capital Gearing Trust. The views expressed above are his own and should not be taken as investment advice.

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