Breaking News
Get Actionable Insights with InvestingPro+: Start 7 Day FREE Trial Register here
Investing Pro 0
Ad-Free Version. Upgrade your experience. Save up to 40% More details

The inflation saga: addressing the elephant in the room

By Acuity Knowledge Partners (Umang Aggarwal)Market OverviewOct 15, 2021 06:21
The inflation saga: addressing the elephant in the room
By Acuity Knowledge Partners (Umang Aggarwal)   |  Oct 15, 2021 06:21
Saved. See Saved Items.
This article has already been saved in your Saved Items

A little inflation is always considered healthy. Why? For two key reasons:

(1) it is expected to amplify consumption as the purchasing power of future cash flow reduces and

(2) it prompts increased investment, enlarging the overall economic pie.

But how much inflation is good inflation? This is a topic that has gained attention recently, especially as global pricing prints have increased since the start of the pandemic. The bigger question is whether the real inflation rate is sitting on a permanently higher trajectory. The answer is critical to determining an expected economic growth trajectory for the US, as it would feed into mortgage costs, stock market volatility, consumption sentiment and overall growth potential.

The Fed has a loosely defined flexible average inflation-targeting framework that aims for a 2% target rate [stated usually in terms of personal consumption expenditure (PCE)] over the long run but is accommodative during periods of volatility and disruption, especially when price increases are assumed to be largely transient. This is interesting because PCE has historically trended lower than consumer price inflation (CPI), which may give some credibility to the Fed’s 2% framework as not being conservative (see figure below).

PCE is generally seen as a better measure because the spending composition better depicts actual consumer behaviour. However, more attention is paid to CPI because it is used to adjust social security payments and is also the reference rate for certain financial contracts, such as Treasury Inflation Protected Securities (TIPS) (TASE:KSMF179) and inflation swaps. Whether we measure CPI or PCE, it is evident that current inflation prints are running as high as they were in 2008 and the 1990s

Headline and core CPI (% y/y) vs headline and core PCE (% y/y)
Headline and core CPI (% y/y) vs headline and core PCE (% y/y)

This year through August 2021, inflation has jumped to an average of 3.8% in headline and 3% in core. Interestingly, if we look only at the latest three months, inflation is significant at 5.3% in headline and 4.2% in core, the highest in 30 years, excluding inflation in 2008, before the financial crisis. Evidently, the current inflation story, whether seen through CPI or PCE, seems to be misaligned with the Fed’s narrative of it being transient.

Is inflation really transient?

Since the first prints that caused concern over inflation, the Fed has remained dovish on changes in interest rates along with the stimulus regime. The Fed only recently ended two of its unemployment benefits programmes that covered gig workers and individuals who had been jobless for more than six months, leading to close to 8m people losing these benefits. This, interestingly, has run parallel to an increase in jobless claims, driven by Hurricane Ida and the spread of the delta variant. This is likely to prevent any imminent hawkish Fed surprises (rate hike expectations are already for 2023). We can, therefore, expect both demand-pull and cost-push inflation in the coming months.

The Fed believes the current inflation spikes are a result of temporary bottlenecks, largely supply-related, as the US economy reopens after the pandemic-induced shutdown. While, one may accept this line of thought in part, inflation remains at levels far above the trend expected pre-pandemic. To understand this, we take a look only at those sectors that are reopening, namely airfares, used cars, entertainment, recreation and lodging and take into account core inflation to discount for the effects of the more volatile food and energy sectors. Extrapolating this data, it is clear that even after discounting for these sectors, core CPI remains significantly high, suggesting that these effects may be less than transitory. Core CPI excluding the reopening sectors would be 4.2% in y/y terms and a whopping 8.1% in annualised terms, suggesting all may not be as simple as the Fed makes it out to be.

While the Fed Chair has already stressed that that the criteria for tapering are quite different from what is required for rate lift-off, and that inflation is not the sole consideration, it is imperative to acknowledge that inflation is ballooning and a return to pre-pandemic levels may not be as smooth or easy as expected, especially when the situation has been exacerbated by a withdrawal of benefits and Hurricane Ida.

Discounting reopening sectors
Discounting reopening sectors

Will delta bring another blow?

Economists, analysts and research houses are of the opinion that while prices will see a downward movement, the magnitude of such a movement may not be significant, meaning that the new price normal will likely be above the pre-pandemic trend and industries and suppliers will eventually adjust to this new normal . Timothy Fiore, chairman of the Institute for Supply Management Manufacturing Business Survey Committee gives examples of price increases in natural gas, fuel and hot rolled Coil, stating that the new price normal will likely be even higher.

Added to this is the issue of rising delta variant cases in the US that could delay a full reopening of the economy. During the Fed meeting, participants highlighted the uncertainty relating to the delta variant and the possibility that it could exacerbate supply and delivery challenges, constraining growth. These shortages have contributed to large price increases and the highest rate of inflation rate since 2008.

Delta variant cases vs change in spending
Delta variant cases vs change in spending

A case in point would be mapping card spending data for reopening sectors such as sports, amusement parks and restaurants to new COVID-19 cases (see figure above). Spending in all reopening sectors has fallen sharply from recent peaks, declining more than during the severe winter COVID-19 wave, when spending was at much lower levels. Slightly positive is the modest softening in restaurant spending. We expect this scenario to peak in a month’s time, considering the experiences of the UK and emerging markets, a situation most unwelcome when supply shortages have already led to a spike in raw material prices and are likely to continue to do so.

That said, the spread of the delta variant may not be seen as severe but is likely to add to the current inflation woes, even if modestly. It is likely to temporarily delay the full reopening of the economy and restrict hiring and labour supply, when unemployment benefits have already been rescinded.

What it means for the global economy

The Fed’s view that the current pricing concerns are nothing but concerns is probably based on its focus on reviving economic lethargy and the roiled unemployment sector. That said, it would be fair to conclude that inflation expectations are climbing higher but at present unlikely to concern the Fed all that much.

However, the global economy is unequivocally tied to developments in the US, and any change to the monetary policy environment would affect the global marketspace. At current levels, the issue is more about supply disruptions and productivity slowdown than about rising prices since industries have continued to accept higher prices. On the other hand, a continued rise in inflation could lead to an earlier Fed rate hike. A rise in US interest rates would imply capital outflow from the US as a more lucrative investment option – leading to USD appreciation and inflation elsewhere. Such capital outflow will likely result in financial market volatility in those countries, with an increased risk of higher interest rates, slower growth and currency depreciation.

Another issue would be paying back debt that has been issued in USD. As the USD becomes expensive, overall debt plus interest would balloon, making the possibility of defaulting or at least deferring payment more real. This would hold true for both private borrowers and official (or government) borrowers. Knowing all this and likely repercussions, we really need to ask, How much is too much?

The inflation saga: addressing the elephant in the room

Related Articles

FactSet Research Systems Inc
Podcast : Financial Market Preview - Friday 3-Dec By FactSet Research Systems Inc - Dec 03, 2021

US futures are indicating a flat to slightly lower open as of 05:00 ET. European equity markets slightly higher, following a mixed Asian trade. Much of the focus remains on the...

Acuity Knowledge Partners
Rising investor demand for ESG in their portfolios By Acuity Knowledge Partners - Nov 30, 2021

“Investments are subject to market risk” is a mandatory statement a fund house makes in an Investment Policy Statement (IPS) when offering investment opportunities to investors....

The inflation saga: addressing the elephant in the room

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind: 

  • Enrich the conversation
  • Stay focused and on track. Only post material that’s relevant to the topic being discussed.
  • Be respectful. Even negative opinions can be framed positively and diplomatically.
  •  Use standard writing style. Include punctuation and upper and lower cases.
  • NOTE: Spam and/or promotional messages and links within a comment will be removed
  • Avoid profanity, slander or personal attacks directed at an author or another user.
  • Don’t Monopolize the Conversation. We appreciate passion and conviction, but we also believe strongly in giving everyone a chance to air their thoughts. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at’s discretion.

Write your thoughts here
Are you sure you want to delete this chart?
Post also to:
Replace the attached chart with a new chart ?
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
Are you sure you want to delete this chart?
Replace the attached chart with a new chart ?
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Disclaimer: Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data.

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.
Continue with Google
Sign up with Email