The U.S. Consumer Price Index (CPI) jumped 7.9% in February from a year ago and core CPI, which strips out energy and food prices, rose 6.4% year over year—levels not seen since the early 1980s. Worryingly, while February was once expected to represent the peak of the current inflation cycle, we’re now unlikely to see that for a few more months as a result of the conflict.
When we studied February’s data, we saw the same dynamics that have been at play throughout the past few months: Services inflation is starting to rise as price pressures become more broad based, but the bulk of price increases continue to be most prominent in COVID-19 distorted areas such as cars and goods.
That said, COVID-19-driven inflation isn’t what worries us. We have had high conviction in our inflation framework and are of the view that this type of inflation should begin to dissipate quickly after February. War-driven inflation, however, is a fundamentally different animal altogether: It’s more nefarious and persistent. As we’ve noted recently, it’s likely to exacerbate and extend the duration of our stagflation base case in the first half of the year and reduce our conviction in a return-to-Goldilocks scenario in the second half of 2022.
We’ve identified five reasons why this new inflation we’re experiencing now is likely to be more problematic than what we’ve seen so far:
1 Increased uncertainty
February was, until quite recently, supposed to be the mathematical peak in COVID-19-driven inflation, but the surge in energy and food prices as a result of the conflict means prices are likely to keep rising until April at least, if not June. Macro visibility is awful at the moment since it’s impossible to know how protracted the conflict will be or how long energy prices will stay elevated. We do know, however, that crude oil prices above the US$110 a barrel mark (specifically, West Texas Intermediate) can be particularly problematic for growth. To complicate matters, history teaches us that energy shocks are ultimately deflationary because of their impact on growth. This means near-term inflation should be modeled higher, but medium-term inflation needs to be modeled lower, making economic modeling much more difficult to the extent it risks being far less reliable.
2 Demand destruction
Arguably, energy and food price inflation has a more prominent impact on everyday life than price surges in second-hand cars and housing inflation. Yes, most of us own a car and all of us need a roof over our heads, but very few among us buy a new car every month, let alone new houses; however, our dependence on food and energy is more or less inelastic. In our view, it’s inevitable a protracted period of elevated food and energy prices will inevitably hurt consumer demand for goods and/or services that are either discretionary or that can be substituted by something cheaper.
"To complicate matters, history teaches us that energy shocks are ultimately deflationary because of their impact on growth."
3 Real wage declines and down sentiment
According to our analysis, in inflation-adjusted terms, wages are already at their worst since 1998 despite recent nominal wage increases.¹ Moreover, wage growth momentum looks as if it might have peaked, implying that real wages could be about to decline further. No wonder consumer sentiment in the United States has continued to decline; the University of Michigan Consumer Sentiment Index, for instance, fell to levels typically seen during recessions in February.
4 A potential return to fiscal support
While the U.S. Federal Reserve (Fed) is behaving as if it’s able to address supply-side-driven inflation, such as port closures with interest-rate hikes, nobody is really expecting central banks to mollify price hikes in energy and food prices arising from military conflict. As such, we’re beginning to hear more about how the role that fiscal policy can play to ring-fence discretionary income (through tax reduction). In other words, we may see increasing pressure to turn to fiscal policy to save the day. That's not a panacea, however, as there will likely be friction on that front given how deficit levels have soared on account of the pandemic—many believe that fiscal conservatism is appropriate.
5 No cover for central bank dovishness
While the Fed is aware that it can’t do much to influence gas and food prices, these massive inflation prints make it near impossible to pivot dovishly until the growth picture starts to worsen and/or signs of weakness in the labor market. Even the European Central Bank—which formulates monetary policy for a region that’s set to be most severely affected by the Russia-Ukraine crisis—kept to its tightening bias and brought forward the pace of its quantitative tightening efforts last week. Indeed, global central banks will need material cover in the form of a clearer deterioration in actual data before they can pivot, which we believe will happen in the latter part of the second quarter.
In our view, investors should brace themselves for official policy rates to move higher—at least in the near term; however, these hikes aren’t likely to do much to ease inflationary pressures. Crucially, investor expectations of the number of rate hikes we’re likely to see this year remain overly aggressive. A dovish pivot, we believe, will be needed soon.
1 Manulife Investment Management, March 10, 2022.
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