Investment Strategy Brief: Stuckflation Failing?
Investors are starting to price in higher inflation as oil prices rise. We take a look at whether inflation will get unstuck for the long-term.
Financial markets have rapidly priced in higher long-term inflation rates — close to or above central bank targets. Is our “Stuckflation Tested” five-year theme at risk of failing? We don’t think so. It will take years for the current cyclical upswing in inflation to become entrenched, if it happens at all.
Policy coordination is driving inflation expectations higher. Inflation expectations are rising for a number of reasons (a robust economic recovery with higher energy prices and a global housing boom). Underlying this is the coordination of fiscal and monetary policy. The generous fiscal stimulus deployed to combat the COVID-19 economic fallout has been effectively funded by uber-easy monetary policy. Interest rates have been cut, quantitative easing programs ramped up and credit support measures initiated. The question is no longer if monetary policy will support fiscal policy, but for how long and to what extent. This is a big change for financial markets, and the collective act of pricing in higher inflation expectations is somewhat akin to demanding an insurance premium in case this fiscal-monetary coordination results in materially higher prices for goods.
Understanding the difference between transitory and self-sustaining inflation. Higher inflation expectations don’t differentiate between transitory and self-sustaining inflation. The former, often driven by “cost-push inflation” (which, in turn, is generally caused by rising input prices), causes inflation to rise briefly but then fades if the price rise is not repeated. For instance, if the oil price rises from $50 to $100 in year one but then remains at $100 in year two, it will cause inflation rates to rise in year one but actually fall in year two as its impact disappears.
Self-sustaining inflation, often driven by “demand-pull inflation,” is very different in nature. It describes inflation that is caused by demand outstripping supply. At the total economy level it is often discussed in the context of the output gap — a measure of whether the economy is operating above or below its potential. If it’s below, there is more supply than demand and there will be little to no demand-pull inflation and vice versa. Economists often use the labor market as a barometer for demand-pull inflation. Labor is interesting because, not only is it a very important input cost (as much as 70% of the cost of production), it is also an important demand driver. The resulting (in)famous wage-price spiral works as follows: when the labor market gets tight, wages rise, incomes rise, demand rises, which in turn causes the demand for labor to rise (on and on). But fear regarding wage-price spirals has often exceeded reality by a wide margin. Not only do we know from 2019 that a low unemployment rate is not enough to cause wage growth to pick up meaningfully, we also know from history that wage growth needs to exceed 4% for a prolonged period of time before we see a correlation to inflation.
Demand shortfalls and elevated unemployment will keep demand-pull inflation at bay. As financial markets price in higher inflation expectations, we must understand whether these higher expectations are driven by a self-sustaining demand-pull inflation a shorter-duration higher cost-push inflation. We are in the latter camp. There is a long way to go before we have dug ourselves out of the COVID-19 recession hole and a lot of healing that needs to occur in the labor market, especially in the lower half of the income distribution. Big fiscal stimulus packages like the current $1.9 trillion proposal by U.S. President Joe Biden will shorten the time needed to close the demand gap. It will almost certainly generate some cost-push inflation. To address this, we have tactically increased our natural resource allocation and rotated into more cyclical equity sectors (including industrials and energy). But the stimulus packages will also allow for a quicker return to normal for the supply side of the economy. And, over time, we believe the long-running disinflationary impact of digitization/automation will keep inflation stuck over the five-year horizon.
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