With inflation rates in the US and UK falling, it would be easy to think we are back in the lower for longer regime. However, David Jane explains why there are good reasons as to why this may not be the case.
While there has been much focus on the near-term declines in inflation, it pays to remember that the medium-term regime remains one of more normal inflation and interest rates.
In the near-term, inflation in the US and UK has been falling, with headline US CPI falling from a peak of 9.1% to just 2.5% in August. In the UK, it has fallen from a peak on 11.1% to just 2.2% now. It would be easy to think we are back in the old lower for longer regime with these numbers. There are good reasons to be concerned that this will not be the case.
One of the more pressing reasons to suggest inflation is to be a more persistent feature of the coming years, is the sheer scale of fiscal expansion in the US and elsewhere. This is being funded largely by deficit spending. The vast bulk of this expenditure is not going to increase productivity via infrastructure or investment in the skill level of the labour force. In the main, it is funding current expenditure. This is inevitably inflationary.
Another area of huge expenditure in the US is its military and that of its proxies. Wars are generally inflationary, money is spent for no productive purpose, indeed wars destroy productive capacity. History would suggest the current escalations in the Middle East will lead to higher inflation.
Hand in hand with the fiscal expansion, goes monetary expansion. Monetarists would argue that inflation is always an expansion of the money supply, which is tautologous. The question is why the money supply is expanding, in the current case because central banks are funding the government deficits. At the same time, the Treasury is trying to keep interest rates low along the yield curve by funding in the short-term money markets, creating a relative shortage of longer dated bonds. Again, this policy will also lead to inflationary outcomes, which is arguably what policy makers seek, nominal economic growth ahead of funding costs.
Another potential source of longer-term inflation is the relative tightness of natural resource markets in areas such as metals and energy, where supply has been constrained by an increased level of environmental regulation while demand is increasing due to general economic growth and in particular ‘renewable’ energy investment. Indeed, that heavy investment in renewables is now accepted to increase energy costs, at least in the near term, again this is an inflationary force.
Another factor which we have written about extensively over the years is the trend towards deglobalisation. History shows that this is always an inflationary force. It might be politically expedient in the near term. It may make nations more secure to have the capability of producing their own needs. Additionally, it should be to the benefit of workers in the West. However, it should be accepted that it leads to an increase in the overall price level over time.
Finally, a short trigger to higher inflation may well be the current port workers strike on the East coast of the US. Barely covered in the media, but disruption of supply chains in the critical run up to Christmas will surely be inflationary if prolonged.
History suggests inflation comes in waves; we have currently come through the first wave of what may prove to be a series of inflationary waves until it is finally beaten. The chart shows inflation from the mid-sixties to mid-eighties in the US.
Source: Bloomberg Finance L.P. CPI YOY Index 31.08.1965 – 31.08.1985
On the opposite side, it is possible to argue that demographics in much of the developed world, is a disinflationary force. In addition, the current Chinese stimulus package will likely lead to further expansion of China’s export sector which was in the past a major drive of goods price deflation.
We don’t like to base our investment strategy on confident predictions of the future. We like to be pragmatic and flexible, but at the same time we do build our portfolios recognising the long-term regime which asset prices trade in. The previous one up until 2021, was one of lower for longer, we would suggest the current one remains higher for longer, despite the short-term trend to reduced inflation. These regimes very much impact our basic portfolio construction strategy. In a higher for longer regime, the downside risk to equities lies in periods of rising inflation rather than deleveraging. Hence, bonds and equities tend to be positively correlated in the medium-term, bear markets for equities tend to see falls in bond markets also. Although, as we saw recently bonds can provide some protection in near term corrections.
David Jane
Premier Miton Macro Thematic Multi Asset Team
