Financial markets are worried about inflation. So are several company chiefs and hedge fund managers who are concerned the US Federal Reserve is not reacting fast enough to curb inflationary pressures in the world’s largest economy.
Last week, Twitter and Square chief executive Jack Dorsey weighed into the debate, tweeting that hyperinflation – typically defined as prices rising more than 50 per cent every month – is “happening” and would “change everything”.
This is an astonishing claim with US inflation at just 0.4 per cent month-on-month and 5.4 per cent year-on-year in September.
Price pressures have undoubtedly increased this year for three main reasons: reopening frictions as demand for some goods and services such as used cars, airfares and hotels outstripped supply when restrictions on activity were eased earlier this year; energy and commodity price increases, again as demand surged while supply lagged; and supply chain disruptions leading to shortages of products and components, as well as pushing up shipping costs exponentially.
However, two of these three inflation drivers are likely to moderate over the next nine to 12 months. Some of the reopening-related inflation has already started to dissipate – airfares, used car prices and hotel rates in the US have declined over the past couple of months and we expect this trend to continue.
Energy costs have increased sharply this year, but crude oil prices are likely to soften in the second half of 2022 as supply increases and demand growth slows. Food prices are also expected to stabilise or even decline from current levels next year.
The third key driver of inflation – supply chain disruption – is probably going to remain a source of inflation well into next year. The spread of the Covid-19 Delta variant in Asia has led to tighter restrictions on activity being imposed, putting further pressure on already strained global supply chains. This has led to higher costs for businesses, some of which may be passed on to consumers although larger firms are likely to absorb some of these costs.
Overall, Emirates NBD expects US inflation to moderate in 2022, but there are clearly upside risks to this view.
One concern for the Fed is higher housing costs, which accounts for about a third of the consumer price index in the US, and which could continue to rise in the coming months.
Another closely watched measure is wage growth, which has accelerated in recent months particularly for lower skilled, lower paid jobs in the retail and hospitality sectors. We would argue that some increase in wages is overdue – wages as a share of corporate income are near multi-decade lows in the US, but with some firms likely to pass through higher wage costs to consumers, there is a risk that wage growth will be a source of inflation next year.
If inflation proves stickier than we currently expect, the Fed may be forced to prioritise one element of its dual mandate – price stability or full employment – over the other.
Tackling the inflation issue by raising interest rates next year could add another drag to the economic recovery if firms face higher costs of capital and slow investment or cut back on hiring plans. That may actually end up alleviating the current labour shortage by reducing the demand for workers, but end up freezing out those who haven’t yet returned to the workforce.
Conversely, keeping monetary policy accommodative, even if prices rise, may not actually prompt workers back into the labour market. There is a panoply of reasons keeping people out of the labour market in the US at present, not least of which is workers holding out for higher wages or because of wealth effects – the equity market rally over the past 18 months has arguably been supported by interest rates close to zero.
Federal Reserve chairman Jerome Powell has signalled that the central bank is ready to start tapering its asset purchases – possibly as soon as this week – but has also stressed that this does not mean that the Federal Open Market Committee is ready to talk about raising interest rates.
The market is currently pricing in two rate hikes by the end of next year, betting that the Fed will need to raise interest rates faster than its own projections imply.
If, as we believe, inflation slows sharply around the time the Fed comes to the end of its tapering in the middle of 2022, and the labour market has not yet reached full employment, then the Fed is likely to hold off raising rates for several months, possibly until early 2023.