Where is inflation heading?
Written and accurate as at: Apr 28, 2022 Current Stats & Facts
Several paradoxes have added further uncertainty across the global economy and financial markets.
- US growth is strong, and earnings revisions are positive — but the market is pricing in a slowdown as the mechanism for the Fed to reduce inflation.
- Measures of investor sentiment are negative — but flows into equity markets remain strong.
- There are signs inflation may be peaking — but bond yields continue to rise.
- Lockdowns are seeing sentiment towards Chinese growth sour — but commodities and resources have been strong.
US inflation and rates
Several signs suggest US inflation has peaked:
- Statistically, we will see the most significant months of inflation growth in 2021 – April, May and June – rolling off the annual figures
- Commodity prices are rolling over off recent peaks
- The US dollar continues to rise
- There are signs of supply chain pressures easing in the US. Shipping rates for freight and containers have begun to fall. There is also evidence of less stress in US trucking systems.
- Employment participation rates are creeping higher. There’s an argument the impact of inflation and the running down of savings is slowly encouraging people back into the job market.
- Company wage surveys have begun to ease. This reflects less pressure to raise wages, which have already been materially re-based.
- Company pricing power surveys are stalling, albeit at historically high levels
Inflation is unlikely to get worse at this point. But before declaring victory on inflation, it’s important to note three things:
- The labour market remains very tight, so some wage pressure is likely to remain
- Supply chain issues could be about to flare up as a result of lockdowns in China
- The US economy remains strong, though there is a shift in demand for services. Coincident indicators are robust. Continuing unemployment claims are at 50-year lows, bank lending is rising 7% year on year, and house prices remain strong.
Key question
The critical question is: if inflation rates have peaked, where do they fall back to? This comes down to two unpredictable factors:
- At what point will the Fed tolerate inflation to avoid a recession?
- The Fed’s ability to control the economy
The Fed maintains a hawkish message.
Federal Open Market Committee member James Bullard mentioned the potential need for a 75bp hike last week. Again, there was talk of an “expeditious” need to get back to neutral. At this point, the market expects back-to-back 50bp hikes are more likely — with the potential for a third — and a start of quantitative tightening. The market continues to price in further acceleration of rate hikes. The consensus is now 2.75% by 2023, versus 2.5% previously.
It’s been a long time since markets faced such a rapid tightening cycle. There is still a question over how this is priced in underpinning investors' near-term caution. There is also a view that Fed tightening cycles will continue until something “breaks” — such as the 2016 collapse in oil prices, the 2012 Eurozone Crisis or the Russia/Long Term capital management crisis in 1998. This is also making some in the market cautious.
China
There has been a rapid deterioration in sentiment towards the Chinese economic outlook due to a combination of:
- Lockdowns choking demand and supply chains
- Currency appreciation relative to competitors
- Global slowdown
- Weak consumer confidence
- Property market remaining fragile
It is estimated that 44 Chinese cities are under some form of lockdown. This equates to 25% of the population and 38% of GDP — of which around 16% is in strict lockdown. Estimates indicate that Chinese growth could slow from 4.8% in Q1 to less than 2% in Q2. This risk is emphasised by a sharp fall in road freight volumes (a reasonable indicator of Chinese economic health) and a backlog of ships off Shanghai. There were hopes that policy easing would see a moderate pick-up in the housing market. This is not yet showing any sign of coming through.
The rise of the US dollar — against which the Chinese yuan is managed — has left China in a difficult competitive position given the relative depreciation in Japanese yen and Korean won. This exacerbates the existing pressure on China’s export engine from slowing global growth and a shift in consumer demand from goods to services.
Under pressure
This pressure seems to have forced a crack last week, with the currency breaking down relative to historical ranges. It moved about 3% against the US dollar. While that may not be large in absolute terms, it is a four-standard-deviation event in historical terms.
The equity market was also battered. The rebound after the government’s comments in support of the market following concerns earlier in the year has proved short-lived, with some signs of outflows in foreign capital.
The policy response so far is regarded as too limited. The People’s Bank of China announced a 25bp cut in the bank reserve requirement ratio from April 25. The immediate impact is concern around commodity demand, which risks being crimped by slower growth and a weaker currency. Aggressive Fed tightening — plus slowing Chinese growth and a devalued yuan — may see a sharp near-term unwind in the sector. This is also materialising in some recent Australian dollar weaknesses.