Viewpoints: April 2022

Central bankers would be the first to admit that domestic monetary policy is a blunt tool for steering economic growth and inflation. Alan Greenspan famously observed that setting policy can be like driving a car while looking in the rear-view mirror. He noted too that arriving sufficiently early “in order to take to away the punch bowl just as the party gets going” is often equally, if not more, challenging.

To extend these metaphors a little further a big problem at present concerns the image in that rear view which is shrouded in fog. In the meantime there is much uncertainty about how many guests have arrived at the party. Even more debatable is whether the punch bowl that's been provided actually contains any punch!

To elaborate on this let's look at a few charts. The first of these suggest the world economy's current inflation tensions are mainly rooted in global supply-side factors. Specifically figures 1 and 2 below show that higher commodity prices in recent months have been mostly responsible for the burst of positive global inflation surprises. That's incidentally as true in the US as it is in, say, Australia. Insofar as higher commodity prices are rooted in global supply-chain bottlenecks that have been choked by both the COVID pandemic and the Russia/Ukraine crisis combatting these inflation tensions via tighter domestic monetary policy will be challenging to say the least.

Figure 1: Inflation surprises in the G10 have been heavily driven by moves in commodity prices

The headlines remain full of negative news about the conflict in Ukraine, a cost-of-living crisis and lingering COVID-related issues not least in China. These factors are derailing consumer and business confidence on the one hand but aggravating inflation tensions on the other. And central banks are accordingly facing an acute dilemma with attendant risks of a policy error extremely high.

One feature of the global economic scene, however, that is arguably receiving less attention than it should concerns the growing desire of companies to invest in new technology and the positive impact from this on productivity growth. As we discuss below the latest dataflow suggest global demand for technology products has been strong, that capex intentions remain firm, and that trends toward technology innovation - and productivity growth - have exhibited ongoing improvements.

On the demand front we can see the evidence for this from surging orders from US companies for capital goods (see figure 1 below) and from surging exports of trade and technology bellwethers such as South Korea and Taiwan (figure 2).

Figure 1: US capex orders continue to strengthen

Although a few presumably temporary factors have lifted reported inflation well above expectations, it is also true that some elements made it look less troublesome. So what is the truth about the current inflation cycle?

The Bureau of Labor Statistics (BLS) provides special aggregate price series that remove the noise, or an underestimate from these factors. For example, BLS published a series of CPI less food, energy, shelter, and used car and truck prices. This series removes the recent temporary spikes in food and energy prices linked to the Russian invasion of Ukraine. It also removes the massive spike in used vehicle prices associated with supply bottlenecks owing to the pandemic. On the flip side, it removes the controversial shelter component that no longer captures house price inflation.

In April, BLS reported this price series increased by 0.6% month-on-month, matching the gain in March and twice that of the 0.3% gain in the so-called core inflation series. This price series has increased by 5.8% in the past year, matching the highest rate recorded in the prior 40 years.

The surge in this price series also represents a significant milestone. It breaks four decades of lower peak-to-peak consumer inflation rates in the business cycle. Business cycles have shown that there is a cycle in prices. Yet, up until the Volcker era, the peak-to-peak was progressively higher. And after the Volcker era, the peak-to-peak inflation rate has been progressively lower or stable.

Also, the surge in this price series shows that the current inflation cycle is not a "blip." On the contrary, it is widespread and more embedded in the decisions and expectations of consumers and businesses.

It is unclear if the current generation of policymakers is aware of the price cycles in the business cycle or how pipeline pressures feed into product prices. For example, the producer price report showed significant increases at all three processing stages in April. It's unlikely that monetary policy can break these price increases with modest increases in policy rates.

Companies need materials and supplies to protect production schedules. Notably, the April survey of manufacturers from the Institute for Supply Management showed that customer inventories are near record lows. As a result, it would take exceptionally high-interest rates to force companies to pull back on the inventory investment needed to sustain production.

Although policymakers have yet to list easy money as one of the causes of the current inflation cycle, it plans to make money much more costly to break the cycle. Yet, how far are policymakers willing to take official rates to reverse the price cycle?

The current official rate projections of policymakers show a peak fed funds rate of 2.8% in 2023, less than half the inflation rate, excluding the unique factors. Never has an inflation cycle been reversed or broken without policy rates moving above the reported inflation rate.

Investors will soon need to confront whether the higher cyclical peak inflation rate is a one-time occurrence or a sustained shift to higher rates? I bet its the latter because the current generation of policymakers is unaware of how price cycles start and end.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Sweden saw inflation jump in March, rising by 2% month-to-month on the HICP measure. This is a much stronger gain than the 0.2% rise in February and even the 0.5% increase in January.

Inflation in Sweden continues to accelerate sharply. Sequentially, Swedish inflation starts at 6.3% over 12 months; that pace rises to a 9.4% annual rate over six months and that, in turn, further escalates to an 11.5% annual rate over three months. Sweden's inflation has jumped ahead and is showing extreme pressure in March.

Inflation diffusion (breadth) A look at the summary statistics on inflation diffusion at the bottom of the table shows that inflation over three months compared to six months rises in 87% of the categories -there are eight of them in the table. Diffusion also rises in 87% of the categories over six months compared to 12 months, and it rises in 87% of the categories over 12 months compared to the previous twelve months. Inflation is accelerating broadly over each of these timelines and the increase in inflation from period to period is significant.

Monthly pressures In March, Sweden posts deceleration in a select few categories: inflation for clothing & shoes with a 0.5 month-to-month drop that is a larger drop than in February shows deceleration; recreation & culture prices decelerate to a 1% pace down only slightly from 1.1% in February month-to-month; in education there is a technical month-to-month drop that does not register rounded to one decimal-both months rad ‘zero' in the table. The upward pressure on inflation in February remains high and broad-based. In February, there are three month-to-month inflation decelerations against a series of much larger increases. January saw decelerations in only two of eight categories while six of eight registered acceleration.

Sequential pressures Of the 24 observations on inflation changes period-to-period (that's eight items over three periods: three-months, six-months, and 12-months), only three show period-to-period deceleration. Obviously over the past year inflation has spread broadly in Sweden. Housing costs gains while high at 7.9% year-over-year (above the HICP pace of 6.3%) proceeded to lose momentum over six months and again over three months. That makes housing a substantial outlying reading. The only other weaking of inflation over these periods is over 12 months compared to the 12-month period of 12-months ago - that is for clothing & shoes. Apart from those three exceptions, price gains accelerated over all three periods in 21 of 24 comparisons – led in each period by transportation costs because of rising energy prices.

Quarter-to-date The quarter-to-date inflation pressures show inflation for the finished quarter at an 8.6% annual rate. This is lower than the three-month rate and lower than the six-month rate. But quarter-to-date figures tend to be more sluggish because they are for the current quarter that's a three-month average compared to the quarter before which is another three-month average. These broad average figures are still compounded at an annual rate and 8.6% is still a particularly high inflation rate. The inflation rate for the first quarter of 2022-to-date is now completed; it compares to a fourth quarter rate of 6.4%. Inflation is still accelerating quarter-to-quarter, a gain of more than two percentage points on the quarterly period. Looking down the line items at quarter-to-date metrics, inflation eases a little bit for housing QTD, for recreation & culture, and for education. However, all other categories show inflation accelerating in the first quarter compared to the fourth quarter. This is not surprising given the strong sequential trend that we see although the quarterly averaging process can produce slightly different reports from the sequential data.

Summing up for Sweden On balance, Sweden is in the grip of the same kind of inflation that we've seen in Germany, the United Kingdom, and the United States. Clearly a good deal of this inflation is driven by energy, by heating oil costs, by natural gas costs, by gasoline costs and by knock-on effects which are a little harder to gauge. However, Sweden, a country with its own currency and not part of the European Monetary Union, continues to show that these same sorts of forces are impacting its economy and its inflation rate. Having a floating exchange rate is not giving it any insulation from imported inflation. Sweden is part of this global process where inflation has moved up and continues to require responses from central banks everywhere except Japan.

Inflation in the United Kingdom surged, rising by 1.1% in March after gaining 0.6% in both February and January. Inflation, using the HICP measure- which is also the CPI for the U.K. - continues to accelerate from a 7% pace over 12 months to 9.3% over six months to a 9.5% annual rate over three months. Inflation in the U.K., like in the U.S. and like in Germany, is running loose and it's too hot for the central bank’s inflation target of 2%. And in the U.K., that target continues to apply to the CPI (or HICP) although the official inflation rate in the U.K. is the CPIH which also includes an estimate for housing services much like the U.S. CPI. The CPIH rose by 1% in March, accelerating from 0.5% in February and 0.5% in January. It is accelerating and a little bit less sharply from 6.3% over 12 months to 8.3% over six months to an annual rate of 8.7% over three months. The rate of change of the CPIH is a little bit less than for the CPI and its acceleration from 12 months ago is also tamer. But the signals and changes are broadly similar.

There's also available, currently, an ex-food, ex-energy (and ex-alcohol) core measure for the CPIH. That metric is also accelerating, the 0.8% gain in March is up from 0.4% in February and 0.6% in January. The CPIH core accelerates from a 5.2% pace over 12 months to a 6.3% pace over six months to a 7.6% pace over three months. This gauge is running a little bit less hot than the CPI and the CPIH, but its acceleration is nearly the same as for the CPI measure.

Turning to the 10 categories of the CPIH in the table, inflation is accelerating in March in five of them. In both January and February, inflation accelerated month-to-month in five of them as well. In addition, inflation in the various headline series also accelerated month-to-month except for February when the CPIH and core measures did not accelerate - but only the core rate backed down.

The diffusion indicators at the bottom of the table capture the breadth of acceleration; these are calculated using even the headlines in the table to provide a little bit more weight to those categories that deserve more weight. The aggregate diffusion measure shows inflation in January, February, and March that has continued to run with pretty much the same breadth with inflation accelerating at about 60% of the categories with some slight let-up in February when that percentage fell to 46%.

Looking at sequential behavior, inflation from 12-months to six-months to three-months we see that over three months there's acceleration across the 10 categories in half of them. Over six months we see acceleration everywhere with one exception that being communication. And over 12 months we find the same thing with acceleration everywhere except for communication.

At the same time, the diffusion statistics show the breadth of inflation over 12 months has moved up to 92% which is sharply higher than it had been over 12 months for the 12-month period previous to this when inflation was only rising in 23% of the categories and the headline for the CPI was up only 0.7%. Inflation over the last 12 months has accelerated extremely sharply and extremely broadly. Over six months inflation has continued to accelerate, running up to a very high pace and accelerating by more than two-percentage points between 12-months and six-months with the breadth of acceleration in 92% of the categories. Over three months there is some backing off as the headline continues to accelerate slightly to a 9.5% pace from a 9.3% pace. The CPIH shows slightly more acceleration (six- to three-months) and the CPIH core measure shows even more acceleration, but the details of the report show that across all inflation readings inflation only accelerated and about 61% of the categories over three months. That is still broad, well above the neutral reading of 50%, but well back of the 92% marks set over six and 12 months.

Over three months in those categories where inflation has backed off accelerating, the results have not been particularly dramatic. For food & nonalcoholic beverages, the inflation rate nicked lower to 8.1% from 8.2%; for housing and household expenditures the inflation rate annualized over three months stands at 5.1% compared to a 6.2% pace over six months. Health care costs rose by only 1.7% at an annual rate over three months compared to 2.6% over six months. Education costs rose at a 3.3% pace over three months compared to 5.3% over six months. And miscellaneous goods & services prices rose at a 1.5% pace over three months compared to 2.5% over six months. While there are 5 categories where acceleration backed off, half of the detailed categories, over three months the backing off was modest and in the end dominated by acceleration in other categories.

Investors should brace for a sharp drop in nonfinancial companies' profit margins as the Federal Reserve raises official rates and shrinks its balance sheet significantly to reduce inflation. History shows that the unwind of inflation cycles tends to trigger an abrupt and sharp adjustment in margins as prices fail to cover overall costs.

According to the GDP data, real profits margins of 15.3% in 2021 for nonfinancial companies were the highest since the mid-1960s. The significant increase in profits margins, up 2.3 percentage points over the prior year, shows that firms passed their higher costs for materials, supplies, and labor to the end customer. Yet, the inflation cycle's flip side shows that margins get squeezed.

The last time the Fed faced an inflation cycle as large as the current one and expressed an explicit commitment to reduce it and achieve price stability was in the early 1980s (the Volcker war on inflation era).

On the surface, today's inflation rate looks less threatening than that of the early 1980s. The current one is more than a year old, while that of the early 1980s was a spillover from the high inflation rates of the late 1970s. Yet, if measured using the same methodology of the early 1980s, today's consumer price inflation rate is as high. Meanwhile, the producer prices for all three processing stages, finished, intermediate, and crude, are significantly higher.

So what matters more for reversing an inflation cycle; the length of the price cycle or the scale and breadth? Policymakers should presume all three matter, and it will take a significant increase in policy rates and luck to break the current cycle.

Price cycles are uneven on the way up and equally, if not more so when the process reverses. Policymakers' projection of a miraculous slowing in inflation to its 2% price target (i.e., roughly a 600 basis drop in the reported consumer price inflation rate) and not triggering destabilizing effects in the economy and labor markets is not credible.

Significant and sharp drops in inflation rates trigger sharp declines in operating profit margins as firms' consolidated costs do not fall as quickly. For example, in the early 1980s, operating profits margins contracted by 400 basis points, and other periods showed even more significant margins decline.

The reversal in the current inflation cycle will not require as big of a policy adjustment as in the early 1980s. Still, the counter to that is that the labor markets are much tighter, limiting how quickly the firms can control their overall consolidated cost structure. As a result, it would not be a surprise that at the end of this process, firms operating profits experienced a decline equal to that of the early 1980s.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Supply chain bottlenecks, disrupted trade flows and commodity price tension have been key hallmarks of the macroeconomic scene for some months now. But are these factors now moving into reverse? High frequency indicators of shipping costs – such as the Baltic Dry Index – certainly suggest this may be the case (see figure above).

This index has enjoyed a fairly tight correlation with indicators of real economic activity in commodity markets in recent years. And unsurprisingly it has equally enjoyed a tight correlation with global inflation surprises. Indeed its steep decline over the last six months presages a period in coming weeks where inflation outcomes could elicit far fewer positive surprises and even a few negative surprises.

This, in turn, could clearly be of some importance for policymakers and interest rate expectations in the period ahead. Indeed a relationship that may be worth watching closely against this backdrop is the evolution of activity in commodity markets and US Treasury yields (see final figure below).

The inversion of the two-year and ten-year yields creates more problems for the Fed and the financial markets than for the economy. That's because the yield curve inversion has occurred at a relatively low level of interest rates, far too low to slow final demand and squash inflation pressures.

History shows that yield curve inversions offer an accurate negative view of the economy's future path only when accompanied by a level of interest rates that prove prohibitive. In the past, restrictive interest rates were when the federal funds rate and market rates equaled or exceeded the growth in nominal income.

Notably, that is not the case today. On the contrary, it's the exact opposite. A record gap exists between Nominal GDP growth of 10% in the past year and the current fed funds of .5%. There is even a record spread between Nominal GDP and two and ten-year yields of around 2.5%.

Yield curve inversion at low-interest rate levels is a nightmare for the Fed. Past experiences dealing with cyclical inflation pressures tell the Fed that it needs to increase the cost of credit to slow final demand before it can successfully dampen inflation pressures.

Take a look at the current trends in the housing market. Mortgage rates have moved above 4% for the first time since 2019. Yet, borrowing costs for a house purchase still are attractive given that house prices are rising close to 20% a year, people's house prices expectations remain at double-digit levels for the foreseeable future, and wages for most workers are growing close to 7%. In other words, money is still too cheap to slow housing demand and house price inflation.

If the bond market is not responding to high reported inflation by marking up yield levels because it believes the inflation cycle will die or it trusts the Fed to bring it under control, that puts added pressure on the Fed to act more aggressively. And, as the Fed lifts official rates to dampen final demand growth and quell inflation, it will encounter market and political backlash of triggering more curve inversion.

A sustained inversion between fed funds, nominal GDP, and market rates may occur as policymakers attempt to bring inflation to their 2% target. After a decade (2010 to 2020) of a near-zero federal funds rate as policymakers tried to hit its 2% price target, investors will encounter of much different and higher cost of credit landscape. One key takeaway is that high-multiple growth stocks which have outperformed value stocks for the past decade should see a "reversal of fortune" in the next decade.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.