global perspectives

Inflation - defying gravity

Inflation - defying gravity
Florian Ielpo - Head of Macro, Multi Asset

Florian Ielpo

Head of Macro, Multi Asset

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we examine the recent US inflation data to ascertain whether the first signs of moderation may prompt the Federal Reserve to alter its hawkish stance. 


Need to know:

  • When compared to its fundamentals (oil, wages and the saturation of productive capacity), US inflation remains too high despite its recent slight moderation
  • Such a disconnect between inflation and its level predicted by economic theory is rare historically but not unprecedented, and seems to occur when commodities rise rapidly (such as in 1980 and 2008)
  • Our nowcasting indicators continue to place the Fed in the hawkish central bank camp, pending a moderation in the housing and employment markets: this is where investors' attention should be focused


The good and bad news in US CPI

Financial markets were again anxiously awaiting the latest US inflation report to answer the burning question of whether we have passed an "inflation peak", i.e. the moment when inflation may still be high but has commenced a welcome decline. Inflation has been a prominent concern during 2022: investors have probably never followed the news flow on this subject so carefully.

On this occasion, the July inflation report contained both good and bad news. The good news was that despite expectations of a continued rise, the data showed its first decline. The decline was limited of course, inflation fell from 9.1% to 8.5%. However, it provided markets with some much-needed relief and interrupted a long sequence of positive surprises that were beginning to make many market participants uneasy.

Now for the bad news: inflation remains high, and its normalisation will require time and above all further rate hikes. Inflation may be beginning to moderate, but the Federal Reserve (Fed) will need to remain aggressive in order to purge the US economy of this disease. Here are some elements underpinning our current view of the situation: yes, inflation is moderating; no, central banks will not "pivot" from hiking rates in 2022.


Inflation: stratospheric and widespread

Inflation remains in the stratosphere. At above 8%, with core US inflation at around 6%, the situation is still more reflective of the 1970s than the 2000s. Core inflation previously reached these levels in 1969, 1974 and 1978, which is enough to worry central bankers. Furthermore, while inflation may not be a global problem, it has affected a large number of countries since Covid's exit: the US, the Eurozone and the UK – wherever excessive demand stimulation took place between 2020 and 2021. 

What remains worrying about this latest inflation report is that, despite its apparent moderation, inflation remains high and appears to be disconnected from its usual fundamentals: energy costs, wage growth and capacity saturation. Over the long term, economic theory agrees that these are the three forces that shape changes in price levels – leaving money supply aside, as its relationship to inflation remains complex to demonstrate empirically.

Figure 1 shows the long-term evolution of US inflation from 1970-2022 and a standard regression model based on these three factors highlighting what should be expected from "theoretical" inflation. While July's inflation stands at over 8%, its core was just over 3%: a considerable gap representing the difference between a Fed that is just starting to pivot and a Fed that is continuing its fight against inflation. Such a gap between "theoretical" and actual inflation has happened twice before: in 2008 when oil prices exploded to USD140 and in 1980, during the aftermath of the second oil shock.


Figure 1. Fundamental modelling of US inflation based on oil, wages and capacity utilisation 

Chart 01.svg

Source: Bloomberg, LOIM


Fed's hawkish stance to stick

It is likely that the Fed itself is surprised by the persistence of inflation and is concerned about these historical benchmarks. This surprise should gradually turn to annoyance, and this annoyance to further rate hikes. A 75bps hike at its next meeting may not be buried so quickly by markets for this reason.

Figure 2 shows that our central bank rate surprise nowcasting indicator for the US gives a similar signal. Such indicators do betray a moderation in the Fed's tone going forward, but also a need for the Fed to maintain its hawkish stance for some time to come: our nowcaster remains above 50% (suggesting the Fed should remain hawkish) but is showing some pullback (the diffusion index is at 31%, with 69% of this data declining). When we look at the breakdown of the nowcaster (the bottom of figure 2), we can see that the labour and housing markets will remain worrying for the Fed, while consumption and prices are showing a welcome decline.

In a nutshell, employment and housing should be the focus for markets, as it will be their moderation that might prompt a dovish pivot from the Fed.


Figure 2. Monetary policy surprise nowcasting indicators: nowcaster, diffusion index and nowcaster decomposition (bottom)

Chart 02c.svg Chart 02b.svg


Chart 02.svg


Source : Bloomberg, LOIM


Simply put, the start of inflation moderation does not necessarily mean the Fed's fight against inflation will end. Any dovish pivot would only occur if the labour and housing markets show signs of moderation.


Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

The main news last week was the US inflation report. Clearly, the report has been interpreted by markets as being rather reassuring, as it dropped to 8.5% against expectations of 8.7% and a previous reading at 9.1%. Looking at the details of the report, the more macro element of inflation – service inflation, which includes shelter costs – is still rising strongly. How we read the report is simple: it is true that inflation moderated, but this essentially reflects a decline in energy and transportation costs.  It is too early to call an end to this period of high inflation, but markets opted to see more in this number than what was actually there. 

Other than the inflation report, the NFIB index showed another decline while PPI indices also retreated to lower levels. The first is bad news when it comes to growth while the second is good news for price pressures: a mixed bag of data globally. 

Europe had light macro news flow over the week. The only point worth mentioning was industrial production, which is indicated as moving lower by our nowcasting indicators;