Despite the word ‘transitory’ being bandied about everywhere, in the context of inflation nobody really knows what it means
Despite the word ‘transitory’ being bandied about everywhere, in the context of inflation nobody really knows what it means
Despite the word ‘transitory’ being bandied about everywhere, in the context of inflation nobody really knows what it means
The chairman of the Federal Reserve Bank must be regretting ever having used the word to describe inflation. Last year the Fed said it would allow inflation higher than the customary annual two per cent to create more jobs. Now that we’re running at three times the Fed’s normal inflation target, Powell probably regrets saying that too.
But what does transitory inflation really mean?
The majority of investment managers agree with the Fed, but ask five of them to define their definition of transitory, and you will get five different answers. And while many are sticking to their original assessment, some are starting to change their outlook after October’s surprise inflation figures with US consumer prices +6% year on year.
Despite the word ‘transitory’ being bandied about everywhere, in the context of inflation nobody really knows what it means. Here’s how Jerome Powell, the chairman of the Fed, tried to explain it last month:
“Transitory is a word that people have had different understandings of. For some, it carries a sense of ‘short-lived,’ and that there’s a real-time component, measured in months”.
The Fed’s view was that current inflationary pressures are caused by temporary problems, primarily the global supply chains disruptions that are causing a shortage of goods. Further, Powell said that for the Fed it’s whether the current trend of rising prices will lead to ‘permanently or persistently high inflation.’ In other words, a 6% annual rise in the price of things we buy, for the foreseeable future. Otherwise, it’s transitory.
The best definition I’ve seen of ‘transitory inflation’ is by research firm TS Lombard: We defined transitory as inflation which dies away without the need for central bank tightening beyond normalisation.
Last Friday we got the November update: inflation at +6.8% year on year, the fastest pace since 1982. For the month it was +0.8%, slightly below October’s +0.9%, but well ahead of the 0.6% consensus. Food prices +0.7%, two standard deviations above the mean of the last three decades. Shelter, the biggest CPI component, up +0.5%, the biggest gain since October 2005. We can go on and on about the details, but it’s clear that inflation is here.
For those still in the transitory camp, if you keep getting surprised over and over again by data, there’s a pattern you’re missing.
The Fed finally came around that they’ve been missing something, and retired the use of ‘transitory’. While all this data is for the US, the increase in consumer demand was global. Even China, which did not do much in the way of stimulus, experienced a 13.5% increase in producer prices (PPI). This is not what you’d expect if the inflation story was just about Fed stimulus.
Inflation, a general increase in prices, has been running at around 2-3% per year for the last century. This is the base case for structural (non-transitory) inflation. Since inflation is a recurring annual phenomenon, transitory doesn’t necessarily mean that an earlier price rise would reverse, just that it would not continue to increase at the same pace.
So, if year-on-year inflation in October was 6%, and then it drops back to the long term 2-3% annual rate, the 6% bump was transitory. But this doesn’t make it any less painful. If electricity prices rise significantly, as Singapore, China, and many parts of Europe have experienced recently, and then settle at the higher rate, there is a direct impact on consumers’ finances. We’re not likely to give up air conditioning or charging our electronic devices. If your electricity bill doubles and your salary doesn’t increase, you have little choice but to cut back on other spending. When the cost of both food and shelter rise, many things change in consumers’ behaviour.
Out of the sub-components of consumer prices, 43 out of 63 were above the prior three month change. So far not only is inflation not transitory, it is actually increasing. The current rise is in its 99th percentile. The Institute for Supply Management Services index, a key indicator of the economy, just hit an all-time high of its 24-year history.
US imports are booming, at US$288 billion in September, another all-time high. Imagine what the demand for goods would be like if there was no global shipping bottleneck. Nestle said earlier this year that input costs were rising faster than they could pass onto consumers early this year. In the latest update they said that not only have things not improved, if anything they have gotten worse. Amazon said it would incur ‘several billion’ dollars of additional costs due to labour supply shortages and increased freight and shipping.
On top of all of this, jobless claims have plunged to the lowest level since 1969. A tight labour market creates increasing wages in the near future.
With all these metrics at multi-decade highs, if you keep getting surprised over and over again by data, there’s a pattern that you’re missing.
Inflation is a regressive tax. It hits low income earners far more harshly. A number of poorer countries are reporting significant inflation in food prices. If electricity and food prices rise by double digits, with no hints of reversing, consumers will severely cut back on spending.
Persistent higher inflation is a significant risk for the economy now. While the Fed has now realised this, they continue to blame supply side issues first, and not their massive helicopter money stimulus after COVID which artificially sent income growth to record levels. To everyone else, it is clear that tripling a person’s income for a couple of years will cause them to spend more, and when everyone does this prices rise. This income growth has now subsided as stimulus is paired back, indicating that inflation will settle back down to the 2.1% range next year. We may not have heard the last utterance of ‘transitory inflation’ as we see some normalisation next year, but all indications are that over the longer term upward price pressures are becoming more structural.
If central banks remain significantly behind the curve, which is the most likely outcome, they may end up losing control of bond yields. This is the single biggest risk in financial markets. Investors would be wise to allocate part of their portfolios to investments that would rise in value in such an event.
By LEONARDO DRAGO
Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.