US inflation has touched a thirty year high in October

US inflation has touched a thirty year high in October

Just-reported US inflation has touched a thirty year high in October. US annual inflation is now at 6.2 per cent with price increases recorded for everything from fuel, new and used cars to rent and supermarket groceries. Investors in the US are now concerned with holidays around the corner, and with supply chains still disrupted, inflation could go even higher.

Keeping in mind the base effect argument – a slowing of inflation next year will look like disinflation when it is compared to this year’s high numbers – the current inflationary surge remains within the US Federal Reserve’s narrative of a “transitory spike”. Investors are nevertheless worried the spike could be higher than is comfortable and may not be transitory at all if it spurs a wage-price spiral. In that case the market might worry the US Federal Reserve’s messaging could shift and rate rises could follow, much sooner after bond market purchases are tapered.

In the most bearish camp are those who believe the US Fed will be forced inevitably to jack up rates with any delays making the subsequent reaction far worse. Subscribers to the bearish view believe a GFC-type crash is inevitable.

They point to the very real fact that in March the Fed did not see 2021 inflation rising above 2.6 per cent. In the March quarter, annualised inflation was five per cent and rising.  On April 28 this year, US Federal Reserve Chairman Jerome Powell said:

“In the United States, fiscal and monetary policy continue to provide strong support. Vaccinations are now widespread, and the economy is beginning to move ahead with real momentum. During this time of reopening, we are likely to see some upward pressure on prices…But those pressures are likely to be temporary as they are associated with the reopening process. In an episode of one-time price increases, as the economy reopens, is not the same thing as, and is not likely to lead to persistently higher year-over-year inflation into the future – inflation at levels that are not consistent with our goal of 2 percent inflation over time.”

Confidence in the Fed and its forecasts is important for inflation expectations so it is vital the Fed’s September forecast for 2021 inflation of no more than 4.2 is not excessively exceeded.

For reasons I have previously explained, including supply chain bottle necks being solved and eased, long term wage growth being limited by both lower rates of unionised labour and massive technology investment in labour-displacing automation and short-term wage pressures being resolved through the reopening of borders and resurgent immigration, I believe the inflation bogey-man is just that – another shadow for the market to jump at.

But the long-term sanguine outlook for inflation does not exclude near-term shadow jumping and consequent volatility.

And indeed, if inflation doesn’t resolve itself through base effects next year, a wage-price spiral is also a possibility.  That edge case would definitely include higher interest rates and possibly a recession.

The US Federal Reserve’s printing presses are now quantitatively easing at the rate of US$105 billion per month – a 12.5 per cent reduction from previous months. The Fed expects to cut bond purchases by another US$15 billion next month – and presumably so-on. With inflation now at 6.2 per cent, the bears believe the tapering is too little too late.

The bears believe, if the Fed was doing its job, QE would have already ended. But consider how quickly inflation has spiked and therefore how sharp the tapering would need to have been to meet that expectation! That rate of tapering itself would have caused the very crash they now say is inevitable and attributed entirely to the Fed. The bears also contend short term rates should already be at two per cent and rising not zero and rising.

The base effect is a major reason for the current spike in inflation. It is so high today because it was so low this time last year. And while the Fed’s forecasts for inflation have underestimated the magnitude of the spike, another twelve months should reveal disinflation as today’s high numbers are rolled off again.

Twelve months is a very long time and stock market investors are notoriously fickle and impatient. Further increases in inflation could test investors willingness to wait out the base effect the US Federal Reserve has hung its hat on.

Australia

Locally, our own Reserve Bank of Australia, upgraded its forecast for inflation and economic growth last week, following stronger-than-expected numbers for the September quarter.  Noting the household wealth effect – to record levels – from booming house prices and an additional $200 billion being squirreled away in savings during the pandemic, the RBA also called out the strengthening labour market, with the jobless rate now forecast to fall to four per cent by the end of 2023.

But it is the tightening of the labour market that is giving the RBA some cause for concern and injecting doubt into its outlook. How consumption responds to the record household wealth will determine whether higher rates of growth and inflation are observed.

In particular, if a surge in consumption and business investment occurs, the impact on employment could induce a stronger recovery in wages with inflation rising to above the RBA’s upper target of three per cent.

The RBA however, not unlike the US Fed, is hanging its hat on inflation pressures, at least from wages, to prove transitory. A recovery in labour ‘supply’ as international and domestic borders reopen, along with spare capacity and “inertia (read; lags) in the wage-setting process is believed to be enough to halt a pick-up in wages such that the transitory base effect on inflation will quell future wage demands, and therefore avoid a dangerous wage price spiral.

In both the US and Australia, concerns about inflation are at this stage, held solely by investors and commentators, rather than central banks.

Nevertheless, that is all that is needed to see some serious volatility in markets. And keep in mind Central Banks might yet change their tune. We currently lean towards supporting the central banks’ view of the world and will, as we always do, focus on individual businesses with bright prospects for structural growth available at what we believe will prove to be rational prices.

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Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.