3 min read 5 Dec 22
Given the current very high levels of inflation we wanted to share our views on the issue and discuss how we are positioning the portfolio to withstand these pressures. Please note that this article is our opinion within the Treasury and Investment Office (T&IO) and should not be treated as advice
We believe that in the long-run inflation is, and always will be, a monetary phenomenon. However, the high price increases we are currently experiencing raise the risk that inflation expectations could de-anchor. This could extend the period over which inflation remains elevated.
Although the current rise in prices began in specific areas that had been disrupted by the pandemic, it has now become more wide spread. Our analysis shows that 80% of the individual components within the CPI baskets of the US, UK and Europe are currently seeing annual inflation increases above 2% and that 50% of items are experiencing price increases of 4% or more. This is arguably the most broad based increase in prices that we have seen in the inflation targeting era.
The consensus view is that these increases are transitory, and that inflation will peak later this year. It is then expected to fall back toward the target rate of 2% as the low prints of earlier periods drop-out of calculations and the short-term factors that have driven up prices abate. While this is certainly possible, it is worth noting that this view is dependent on a degree of mean reversion and relatively simplistic modelling that may not play out.
For inflation to fall back toward target, we will need to see month-on-month price rises of around 0.2%, however, currently prices are rising at a much higher pace. Producer prices are increasing at around 2.5% month-on-month and there remains significant uncertainty around the key variables that have impacted prices in recent months namely, commodities, supply chains and housing.
The uncertainty surrounding these factors means that we need to be cautious about the near-term outlook for inflation. There are clear risks that inflation could continue to surprise to the upside. In addition, some of the more medium-term drivers of prices are also starting to move from having a deflationary to an inflationary impact.
First, there are signs that central banks are having less success restricting the pass through of price rises than they had before the pandemic period of the inflation targeting era. The longer prices remain high, the more chance that expectations become detached from central bank targets. This has important implications for the speed in which central banks tighten policy or allow inflation to remain above target.
Second, the move away from globalisation toward regionalisation is a shift from a disinflationary to an inflationary model.
Third, the retirement of the post war generation could mean that the consumption habits of this influential demographic shifts. While the impact is still widely debated, research does suggest that as the older generation retire they shift from being net savers to net spenders. In so doing, their impact is thought to move from being disinflationary to inflationary. That said, although backed up by academic research, this effect is yet to be seen in Japan.
Finally, as countries seek energy security and move toward renewable sources with emissions more accurately priced, energy could well become an inflation impulse over a multi-year horizon.
So what does this all mean? For us, Milton Friedman’s dictum still holds. Inflation remains a long-run monetary phenomenon, but undoubtedly there are factors, some of which may well have an impact over decades, that are exerting upward pressures on prices. These factors could mean that inflation remains elevated for longer than expected.