Recent data suggest inflation in the US may have been dormant in recent years, but is not extinct. This has important implications for how we think about our fixed income strategy.
Tim Drayson, our head of economics, flirted with a career in geography before becoming attracted to the dismal science. As a student of physical geography, he no doubt studied volcanoes carefully.
Volcanoes can be either active or extinct, and active volcanoes can be subdivided into those that are erupting and those that are dormant. Dormant volcanoes look like extinct volcanoes but, as the people of Pompeii and Herculaneum discovered in AD79, it’s a really bad idea to assume that they are one and the same thing.
Many economists and market strategists had written off US inflation as extinct. A Bloomberg article from earlier this year sums up that consensus nicely: ‘the disappearance of the age-old bogeyman confounds central bankers and economists’. Tim’s never been in the ‘end of inflation’ camp. I like to think that his background in geography helped him to distinguish between the dormant and extinct states of the inflation process.
So what has happened to suggest inflation was only ever dormant? Over the past three months, US core inflation has more than made up for the surprising weakness earlier in the year. Including last week’s data for August, we have now seen:
• Three consecutive months of inflation at 0.3% month-over-month for the first time since 1995.
• The strongest three-month annualised rate (3.4%) since 2006.
• The strongest year-over-year rate (2.4%) since 2008.
The big question is whether the latest data represent the first rumblings of an inflation eruption that would be catastrophic for risk assets.
Before getting too excited, we should note that the recent run rate overstates the underlying trend: apparel, used cars and trucks, airline fares, and financial services prices have just normalised from earlier weakness. Core goods prices have picked up too, although it is hard to see a meaningful impact from tariffs at the component level.
So far, inflation has been a bigger issue for the debt than the equity markets. This month’s back-up in yields has been driven, at least in part, by the pick up in inflation. More directly, we’ve been advocates of US inflation-linked debt for months. Pricing at the short end of the inflation curve looks even more extreme against a backdrop of strengthening price pressures. Put simply, investors do not have to pay much to protect against rising inflation.
Higher inflation may further complicate monetary policy for the Federal Reserve (Fed) too. The Fed will now feel more confident that it is meeting its inflation target and will therefore struggle to justify future rate cuts on the basis of a persistent undershoot in inflation. The case for further easing now rests on the weaker global growth backdrop and trade policy uncertainty.
As I am sure Tim knows, there are six different types of volcanic eruption: Icelandic, Hawaiian, Strombolian, Vulcanian, Pelean, and Plinian.
Investors are always looking to protect against the financial equivalent of a Plinian eruption, the type of spectacular explosion that destroyed Pompeii. For the sake of financial markets, we should hope that the inflation eruption is of the more gentle variety associated with Iceland and Hawaii.