Market, Corporates and Central Banks’ View on Inflation

Commodity prices and CPI subcomponents continue to flag an increased risk of inflation.

Market, Corporates and Central Banks’ View on Inflation

In This Publication

Commodities, CPI & Labor

A couple weeks ago, very few people were contemplating a tapering of bond purchases by the Fed, but that changed after US CPI data exceeded expectations and the most recent FOMC minutes indicated that tapering-related discussions have already begun.

Ground zero for the inflation narrative tends to focus on the surge in commodity prices:

Commodity prices are mainly considered inflationary as they’re input prices for major products (higher grain prices makes raising cattle more expensive, leading to higher meat prices), but in terms of short-term direct impact, few commodities have a meaningful impact on CPI outside of oil (via gasoline) given the time lag between, for example, grain consumption and protein manufacturing.

Many of the CPI subcomponents, which have a more noticeable impact on headline inflation numbers, however, are prone to short term gyrations:

Inflation is also starting to creep into wage data. The paradox here is that companies are trying to hire but they can’t find employees, not because there is a shortage of labor, but because of a skills mismatch.

Many parents are unable to re-enter the labor market because they can’t find child support, whilst others who lost their jobs in the ‘old’ economy don’t have sufficient skills to transition directly into technology-based roles.

The mismatch paradox between supply and demand of labor only grows larger given:

Job Openings, a proxy for job availability, now stands at a record level of 8.1 million, but the unemployment rate is still double what it was pre-pandemic.

A shortfall in labor, at a time when fiscal measures continue to support consumption, carries a number of consequences.

The arguments for higher inflation continue to be very reasonable, at least in the short term. Let’s see how the reopening impacts all of this, as we still believe inflation is less permanent and more transitory than what consensus thinks.

What Does the Fed Think?

The Fed wants the economy to overshoot. They have moved to an average inflation target of 2%, which gives them leeway to let inflation exceed their target for an unspecified amount of time.

How Are Corporates Reacting to Inflation Risks?

Inflation mentioned in quarterly reports increased by 800% Q-on-Q.

That said, the actions of the corporate sector tell a different story:

If corporates believed in the permanence of the price hikes, then they would be investing in growth, not shares. Diverting capital to buybacks helped undermine productivity over the last decade, and this apparently continues to be the case for the 20s as well.

Additionally, commercial bank loan growth has just dipped back into negative territory.

Whilst part of this is due to the base effect after last year’s surge in emergency loans, it continues to signal that commercial banks (which drive the real supply of money available to the consumer) still don’t want to lend and that corporates don’t want to borrow.

Inflation beyond bottlenecks and base effects will be fleeting if the corporate and financial sectors show little interest in embracing growth.

Reactions to Tapering...

Although some of the current levels of pricing pressure are historically commensurate with rising interest rates, the decision to taper or to tighten should be treated as two distinct and sequential decisions.

Policymakers will first taper (begin to reduce their bond purchases as the Fed did in 2014) before they tighten interest rates (as the Fed did in 2015).

Taper without a Tantrum? It’s the key question for markets.

The taper also set off a chain of events that caught policymakers by surprise.

Policymakers have learned from those lessons.

The current setup seems to imply that nominal bond yields may have already adjusted to the expectation of a taper, but the rise in inflation expectations has kept real yields depressed at the levels where the Fed announced its taper in 2013 (as a reminder: Real Rates = Nominal Rates – Inflation).

When thinking about the risks of higher rates, it’s important to stress that investors and policymakers are far more aware of the bond yield versus growth dynamic today than they were in 2013:

A taper announcement today should therefore be far easier to digest given the policy toolbox, the market’s experience in this theme, and the willingness of governments and central banks to keep the economy and markets at support levels. This all means that higher nominal yields are a smaller threat.

Realistically, a tightening of monetary policy may even help relieve some of the current inflation expectations that have started to unsettle financial assets.

For all the hate they get, one needs to acknowledge how policymakers’ don’t have it easy at this point:

Whilst it’s unclear what lies ahead of us, we do believe that markets should be able to digest a taper today far better than they did in 2013. Whilst the biggest risk remains inflation, prices could stabilize permanently higher if policymakers remain loose on both fronts.

Published in: Markets
Roger Hirst

Leads all Macro research and content. Previously equity derivatives hedge fund sales and Delta-1 basket flow trading.

View articles

Great! You’ve successfully signed up.

Welcome back! You've successfully signed in.

You've successfully subscribed to Lykeion.

Success! Check your email for magic link to sign-in.

Success! Your billing info has been updated.

Your billing was not updated.