Has inflation peaked?

Far-reaching, persistent inflation continues to be the dominant economic theme across the globe. 

In our latest Fixed Income TEAMTALK podcast, abrdn experts discuss the likely inflation trajectory. Have we reached the inflation summit yet, and where do we go from here? 

Join Fixed Income Investment Specialist Peter Marsland, Head of Inflation Adam Skerry and Research Institute Senior Economist Sree Kochugovindan for an in-depth analysis of the inflation outlook. 

If you would like to subscribe to our Fixed Income Newsletter click here.

If you would like to listen to the previous episode of Fixed Income Explained Podcast click here.

Transcript

Fixed Income TEAMTALK

Peter Marsland: Welcome to the Aberdeen fixed income team talk. My name is Peter Marsland. I'm an investment specialist at abrdn, and today I'm joined by Adam Skerry, who's the Head of Inflation within our rates team. Hi, Adam. 

Adam Skerry: Hello. 

Peter: And joining us is also Sree Kochugovindan, senior economist within our Research Institute. 

Sree Kochugovindan: Hi, Peter 

Peter: Today, the topic is inflation. But before we dive into that regular listeners to the podcast will know that we like to start the team talk with a bit of more of an offbeat question. So, today's question is, what past music or sporting events do you wish you had attended? And I'll open it up to Sree.

Sree: That's a very good question. I think it will probably be a concert from a few decades ago, someone like Ella Fitzgerald, I think that would have been amazing to watch her perform live.

Peter: Well, great live performer. And same question for you, Adam.

Adam: I suppose I have to go back to the 70s. If we're going to be talking about inflation, I suppose going back to then, is the sort of most relevant decade. So, you know, seeing Led Zeppelin, Pink Floyd on the sort of concert front.  Sporting-wise probably the 1970s going back to the Derby, Nijinsky winning in ‘70. If I could take the list of winners with me, that would be quite handy as well.

Peter: Very good. And for myself, I think I'd have to go for a musical event, I'd have to go back to 1985, I’d just left school, just started going to concerts and would have loved to have gone to Live Aid at Wembley, I think that would have been a fantastic event, just the iconic spectacle that it was, but some of the great performances of that day would have been fantastic to see firsthand. 

Okay, let's move back into modern day then, and to the main topic that we're going to discuss today. And it's obvious that, you know, the elevated levels of inflation that we're seeing at the moment continue to be, you know, the dominant story and economic theme across the globe, for governments, central banks, and also for the general population. And the notion of this “transitory phenomenon” for inflation has been replaced by a realisation that it has become more persistent, and far reaching than previously thought. 

Now this has resulted in many central banks increasing base rates sharply in an attempt to tame the pressure upon prices. And market expectations are that they will be broadly successful in achieving this objective, particularly as some of the pandemic-related issues begin to ease. 

However, looking further forward, there are a variety of longer-term structural issues at play, that can't be completely overlooked when we consider the outlook for future inflation. So is it also possible that these headwinds could result in a more well in a more persistent, higher inflation environment than we're used to today? 

So to cover these and to tackle some of those points, I'm now going to pose a few questions to Adam and Sree to get their views. So let's kick off with you know, we had a big, big news yesterday with the US inflation print. So what are the main drivers at the moment to the higher inflation environment that we’re experiencing? What are the main drivers? Is it mainly due to higher energy prices? And I'll get you to kick that off, Adam.

Adam: Yeah, sure. Thanks Pete. In short, I mean, yes, the commodity story is still there. And it's still I think, the thing to kind of highlight is that it's still extremely volatile. So in terms of the changes that we're seeing in energy prices, you know, whether that would be oil, whether that would be in gas, it depends, you know, sort of region to region, country by country, but it is still a driver, it is likely to remain, as I say, a sort of volatile component of the overall inflation picture. 

But I think what's more troubling or has got the attention of the central banks more is that the core inflation components have been particularly strong. And they're the elements that can be more sticky, more persistent, the ones that, you know, weren't transitory when we heard Jerome Powell, over the last couple of years ago, sort of saying, you know, it should blow over. 

The way that this has kind of evolved has meant that core inflation has been much more persistent. And so, as you say, even in the last few prints, we've seen that there's even been a divergence within that core component. So you've got core goods prices, which are actually levelling off and in the October print, so the most recent one we had yesterday. It actually went into negative territory. So, core goods prices have kind of come off relatively kind of sharply. And that's really just a reversal of the kind of COVID surge that we saw. So when we all went into lockdown, we all went out and bought new laptops, we went out and bought new desks and whatnot. So that has actually reversed, so the demand side there on the good side has kind of been mitigated. Sree can probably talk some more about the supply side easing there. So there has been a kind of easing of the supply bottlenecks that were kind of endemic within the pandemic. 

But on the services side, again, which has kind of caught the attention of the central banks, there's still persistence there. And that is something that generally does last a little bit longer. And it's much more closely tied historically to what the labour market looks like. So, because a big part of the services cost base is down to that labour input cost. If we do think that the labour market can remain tight, then you can see more persistence within that service sector. So it's those kind of issues that the central banks are really trying to grapple with, and make us think that we've probably seen the peak in kind of headline inflation, particularly in the US, which was in June this year - so June 22. 

The peak in European and UK inflation is likely to be the kind of October, November prints that we see in the next month or two. And then there'll be a trajectory downwards. But it's where - the big question for us is really where that plateaus. So you know, where does that actually level out? But, but yeah, but they're the key drivers at the moment.

Sree: Yeah, I think I'd agree with all of that. Adam, I think I’d just add in terms of you're right, it has peaked in the US definitely yesterday's inflation print was quite, was quite encouraging. But I think it's, we need to be a bit careful about reading too much into the one print. And what I would highlight is just picking out on one of the points that you made. Oil price, obviously, you know, it’s going to stay quite high and elevated and food price spikes potentially in the next few months, as we go through the winter months, there could be some more volatility there. But again, as you mentioned, that has peaked. 

And we're likely to see quite a sharp disinflationary drag from that over the next few months going into next year. But again, as you, as you say, it's headline and what the central bankers are more interested in is what's happening to the core and the underlying inflation pressures. And there if we look at the supply chain bottlenecks, there's definitely easing. some of those pandemic distortions, they have improved quite markedly, but they're still, you know, this is a slow recovery, and there's still some distortions, there and you can start by looking just geographically, China's zero COVID strategy is still in place. 

So we're not seeing the perfect storm of disruptions that we had experienced say in 2021, where we had the Delta wave going across Asia,  and that was really hitting that global value, global production hub, in a sense, that was really causing a lot of distortions, and pushing up core goods prices as a result. So we've gone through the peak there, but there's still some distortions there. As I say, China, zero COVID strategy looks like it's going to stay in place for a meaningful period of time. 

And what we're seeing is pockets of supply disruptions and pockets of excess supply, actually. So that's going to be quite interesting to see how it's impacting different sectors. But also, we're going through a period where, you know, yesterday's US CPI was quite interesting, how used car prices came down quite sharply. So again, we are seeing an improvement there. But that's going to be a slow process in terms of core goods prices improving. 

But as Adam has already highlighted, its core services that’s really quite worrying. It's the wage pressures that continue to stay quite elevated and quite strong in the US. And that's going to be the one to watch there. And the reason that's so important is because inflation expectations depend on that. The longer we stay in this period of high inflation, people are going to start pricing that in, and we will see that in the way firms set mobile phones tariffs  for example, that's one example we look at, they don't just look at their input costs, they add on a little bit extra to take into account that that tariff needs to account for inflation going forward. So we'll see it's important to watch these sort of micro level movements as well going forward. So I think yesterday's data was encouraging, but just to look out for, you know, future trends, and really, its expectations that's going to be quite important going forward.

Peter: Yeah, I think that's what underlines the sort of complex nature of the factors that are driving inflation, whether its core, non-core, whether it's energy prices, etc. So I think it's, it's quite a complex picture. And with some of those sort of on the way up, and some of those sort of on the way down, it's interesting to see how the market is pricing where inflation will be in the sort of medium term over the next couple of years. So how likely is it that inflation actually does return to the levels that are being predicted by the markets? Because they're almost forecasting that they'll get back to where central bank targets are? And I think that's going to be quite an interesting dynamic to see play out. So how likely is that Adam, do you think?

Adam: Yeah, well, I mean, if our starting point is what's currently priced into the front end of these inflation curves, if we look at the kind of the US sort of fixings market. So what it's saying is that, you know, yesterday's print was kind of, you know, in the high sevens, that's going to come down in CPI terms to around about 5% in March next year, and then that's gonna come down to around 3% in June, and then really just level out around that. So going into kind of 2024, CPI is seen as being kind of in the sort of 2.8% to 3.2% range. So that is still above the Fed’s 2% target, albeit a sort of flexible average inflation target. So, you know, the market is saying, yes, the Fed are going to be successful, they're going to be able to pull down headline CPI. But it's still going to be slightly above where we've seen it historically you kind of see it and slightly above where the Fed are kind of targeting. 

I think for us, it's where that plateau actually happens. So yes, you know, as Sree’s just pointed out, you know, we've seen the peak, it's coming down, but the kind of, the bigger question for us and for the markets really, is, where does that actually sit? Where does it actually level out, and we say - Okay, this is a level of inflation that we're happy to kind of sit with. And I think a lot of that is going to be determined by what the economic backdrop is, when we go into that kind of environment. So if we think that, as is kind of priced at the moment, that we're going to be going into recession in the US, then, you know, the Fed are going to have to sort of shift more away from just purely looking at the inflation side of their mandates, towards the unemployment side of things to actually consider the impacts that tighter financial conditions are going to have on growth. 

So, you know, on top of that, you've got the sort of fiscal question as well as whether there is going to be any fiscal intervention. The US political dynamic is still a little bit up in the air, because we haven't got the full results yet from the midterms. But, you know, if the assumption is that there's not going to be an awful lot of fiscal stimuli coming, or a lot of fiscal policy kind of implemented, then the emphasis again, kind of falls on the Fed to kind of be the release valve in terms of if there is needed to be looser conditions, tighter conditions, whatever kind of is needed at that given time. So, you know, I think there's still an awful lot of uncertainty around it, but to our mind, the sort of the structural drivers that we look at, when we look beyond the next kind of 12 months and say, - Okay, how persistent can this inflation dynamic be? There's more upside risks than downside. So, you know, we do think that there is a chance that inflation can be stickier for longer, but not at such a level, that is a problem for the Fed. Because when they've got that flexible average inflation target, they don't have to hit 2%. month on month, quarter by quarter precisely, they can afford to have a little bit more kind of wiggle room, which to our mind means that inflation can sit at a level above that for a significant amount of time.

Sree: Yeah, I think it's a really challenging backdrop for central bankers right now. And I think the way policy is set at the moment is gonna be quite critical for the path of inflation going forward. We've been talking in previous research reports about the trade-off or the sacrifice, how much activity is going to be sacrificed in order to tame inflation and that there is that trade off, unfortunately. So at the moment, what we're seeing is, household incomes being eroded by higher energy prices, utility costs, food prices, but also mortgage rates, borrowing costs, you know, as the Fed, and central bankers everywhere, are hiking rates, this is really eating into household incomes, corporate incomes. And we are of the view that there's going to be a recession as a result of this. But we're also with the view that that's actually necessary in order to tame inflation now - it's better to be aggressive now, in order to prevent a 1970s style escalation in prices and allowing inflation to sort of escape in the way that it did back then. And that was actually a policy error. So I think one thing to really…investors should be focusing on over the course of next year, is this idea of the pivot. There is a lot being made of, you know, the fact that yesterday's print was so much better that the Fed can take the foot off the pedal, but would that really be so wise just yet. In a way you need to take some of that excess demand out of the system, and that might take a recession - a short one, hopefully, but unfortunately, that's necessary in order to tame inflation. It would be better to do that rather than have a much deeper protracted recession and further hikes. If they were to pause or ease too early, that would be a mistake, potentially. So that's something just to be aware of going forward.

Peter: Yeah, there certainly seems to be a bit of a dilemma that central banks are facing at the moment between the whole - taming inflation or choking off economic growth altogether - dilemma. So while definitely one to watch, and I think with what we've seen with the Fed in the last few years, where they moved to that, that flexible, average inflation targeting and the ECB have even softened their language around exactly what they mean by the final inflation target. Do we think that the central banks will persist with a with a specific inflation target going forward? If inflation stays stubbornly high? Will they tend to be tempted to move the goalposts? Or are they wedded to this sort of 2% inflation target going forwards do we think?

Adam: Yeah, I think the immediate heat has come off the central banks to some extent. So in the UK, you know, you had Liz Truss, who was sort of quite adamant that she wanted to bring into question the independence of the Bank of England, that's kind of calmed down somewhat. And it seems that generally there is an acceptance that the central bank targeting of their current inflation levels, ie 2%, across most of the developed markets is a sensible one. And is not kind of, to the detriment too much to the rest of the economy. Now, that's, that's quite easy to say, when you've got unemployment down at kind of historic lows, you've got growth that is still kind of holding in relatively well, albeit slowing. 

It perhaps comes into question more, when you've got lower nominal GDP growth, you've got unemployment that's picking up, you've got higher funding costs for business and you're starting to see kind of fractures appear in the balance sheets of both corporates and households, as that cost of living and the financing costs are increased. But I don't think there's any kind of immediate pressure on the central banks to really shift away from that 2% target. 

The other question is, given the size of the debt piles that are out there, both in terms of sovereign debt, corporate debt, household debt, is a little bit of inflation necessarily that bad a thing? Will governments and central banks actually go well, in terms of eroding some of that enormous debt pile that we've got having inflation running at a kind of two to 3% kind of level, is that necessarily such a bad thing? 

Yes, that is slightly above their kind of mandated targets, but it's, you know, for the greater good, perhaps that's not such a bad thing. But yeah, it's all kind of, it's a huge debate. And it's one that's kind of centred again, around the sort of blurred lines now between central banks and fiscal authorities. So, when you've got governments kind of trying to implement policy on one side, you've got central banks potentially sort of pushing against that. So, you know, you've got kind of fiscal expansion by governments, but you've also got central banks, trying to sort of push against that, where that kind of line actually becomes blurred. So you know, for example, in the UK, there's been an awful lot of chat recently, and even today about the kind of level of mortgage lending, the availability of mortgage debt, so if the Bank of England are targeting inflation, and they're just going to be fairly kind of myopic about that, and just keep targeting it and hiking rates, to get that inflation level down - does that absolutely kill the housing market? And on top of the cost-of-living crisis, we've already got, will it take the fiscal authorities - so you know, the government - to step in and say, actually, we're going to put targeted kind of policy in place, that means that people aren't going to be kind of kicked out of their homes, we're not going to foreclose on these mortgages. So again, that probably has to come from the government legislation side, in conjunction with something that the Bank of England can do, whether that be sort of forbearance on mortgages, or whether it's sort of legislation around banks, being able to offer mortgage holidays, that kind of thing. I think there's going to be a lot of flexibility and a lot of discussion between, as I say, the central banks and the governments, which is a big open-ended question. 

But for the near term, I think everyone realises that getting inflation down from these historically, very, very high levels should be the priority, whether that actually ends up getting inflation back to 2%, or whether it's something slightly above or slightly below is yet to be seen, but I don't think there's any imminent change to the mandates of the major central banks at the moment.

Sree: Yeah, I'd agree with that as well. I think the example of the UK is perfect really. We saw how credibility is so important, central bank credibility has been a big role over the last 20 years or so in, in bringing inflation to stable and low levels. So any threat to that we could see there was an instant reaction really, market discipline. Because at the start of the pandemic, there were a lot of questions about, you know, inflation being used to erode away debt, and how easy can that be for governments to do overtime, or we've seen that there was a very quick response from the markets in order to you know, we've seen the changes, political changes since then. And if anything now, there is, as Adam’s saying targeted support through this winter, so we can think about the energy price support. But the overwhelming focus is on how to move forward with some fiscal discipline. So we're talking tax hikes now, which is a complete reversal of where we were just a few weeks ago. So again, I would agree with Adam, I don't see any meaningful change there in terms of central bank mandates, I think they're quite safe in their independence for now.

Peter: Okay, so no change to come, we think in that regard. But looking further ahead, some of the sort of longer-term impacts or trends that could influence inflation and the way inflation develops. What are we seeing there that could sort of maybe cause us to think there's more of a sort of headwind to longer term inflation than the sort of tailwind we've enjoyed over the last 30 years? And with an economist hat on Sree, maybe you could kick this one off?

Sree: Yeah, I think, you know, we've had some really important structural drivers over the last 20 years or so, that have been helping to bring inflation lower over time. So the first part would be the demographic trends. You know, we had globalisation, technological progress. And these are all quite interconnected in a way. So globalisation actually has an impact in terms of having a global workforce and being able to relocate, so that you can take advantage, the comparative advantage of a different country, whether that's cheap labour, or cheap production costs, and so on. So really taking advantage of the skills and the workforce there. So when you think about demographics, you need to think of it within that global context as well. But obviously, there is some, there's been a lot of debate now about what happens going forward, are these drivers becoming much more inflationary? 

And what I would say, first of all, is that these structural drivers, they either act as a tailwind or a headwind to inflation. Okay, so they're not the main driver, the main driver, I'd say, is still central bank policy. For us to move from one inflation regime to another whether it's meaningfully higher or meaningfully lower, it really depends on central bank policy, the policy mix - and that's primarily monetary – and also the inflation expectations. That's what leads us into a much, much more different inflation regime. And that's what we saw in the 70s. So I would say that that's more important than these other drivers. These other drivers are slow moving, but are still important, and that they will provide a sort of a tailwind or headwind, as I said earlier. 

So I'd say the globalization's obviously been a big point of debate. We've had the pandemic and we've seen, you know, this focus on good security, healthcare goods, tech, semiconductors have been so disrupted - the fact that the semiconductor supply chain is so fragmented and crosses multiple borders multiple times. So that's been, that's really brought everything to light, we just didn't realise before how integrated that supply chain had been. So that has been a focus and we've seen different legislation focused at semiconductors or some moves towards re-shoring, which is a bit different to what we saw before in terms of the trade wars that we had had before. So these are slow moving processes. 

But what I would say is globalisation isn't just about trade. So if you look at trade, then yes, that's been a slowing trend. But technology is also very important, the diffusion of tech and knowledge, that's all part of the story as well. And that you can't move away from. So I would be a bit careful about saying, well, globalisation is you know, is going to, you know, into reverse. I think that's going to be very difficult to disentangle the intricate supply chains that have been put in place over the course of 20 years. That's going to be very difficult, but there will be some re-shoring - we're seeing that and a slower pace of trade. But does that necessarily mean more jobs at home? Not necessarily because there is this tech evolution as well, so a lot of these processes will be automated to an extent. So I think it's quite important to keep an eye on both of those trends together - the trade and the tech trends as well. 

And obviously, there is a lot of focus on demographics, and the fact that many developed market economies are going through an ageing process. So that will reduce the workforce to an extent. And that's something that I've been looking at, you know, looking at the structural drivers together - demographics, trade and tech. And I have to say, in my analysis, demographics is very slow moving, it’s probably the least important from an inflationary perspective. Yes, it's true that there'll be drivers of certain prices for certain goods, I mean, healthcare is going to be a big story for the next 10,15 years. And so certain sectors will be impacted more. But I would say, trade and technology need to be investigated and watched very carefully. But as I said before, it's the policy mix, that's really going to be the big driver of any future trends and whether or not we shift from one inflation paradigm to another. And that example of the 1970s, I think, is quite important, where we saw that shift in that relationship between the level of inflation and the level of unemployment - to keep it quite simple, that relationship shifted in a in a very detrimental way. And again, it's policy that's the main trigger there.

Peter: Thank you Sree, anything to add to that Adam, briefly?

Adam: Yeah, just in brief, and just bringing it back to what markets have got currently priced. I mean, if you think inflation is going to be persistent, or it's going to be slightly more sticky, for the reasons that Sree has pointed out in the longer term, then you look at where the break evens are currently. I mean, in the US, 10-year breaks are around 2.4%, Europe 2.3%. So that is saying, it's almost Goldilocks, that they’re coming straight back down to, you know, inflation target, it's all going to be a kind of, you know, storm in a teacup and over the long term, then inflation is going to be absolutely nothing really to worry about. So, if you are sort of more slightly concerned about those longer term drivers that you think inflation could be stickier for longer, then you know, break evens, those kind of levels, to me still relatively attractive, you know, there's not, you're not paying a huge amount of insurance premium for an upside risk. 

And likewise, in terms of real yields, I mean, if we look at the US real yields now in 10-year around about one and a half percent, so you're getting paid one and a half percent over and above whatever inflation prints at, which again, looks reasonably attractive, If you do think firstly, there's an inflation risk in the long term. So you're going to get, you know, you're, you're protected against that, because your coupon will be uplifted by that. But also, if you think we're in a world where we could be potentially going into slow down, recession, you know, things are looking a little bit uncertain for other asset classes, then to be able to lock in a real return of one and a half percent - particularly you think the Fed are, you know, kind of reaching or getting towards the peak in sort of Fed funds rate or base rates -  then, yeah, still looks on a longer term basis, relatively attractive.

Peter: Well, I think that's, that's very interesting. And it's, it's clear to see that inflation is going to be a key story and an interesting story for the months ahead, and we'll see what transpires - so plenty of food for thought there. 

So just leaves me to thank both of our contributors today, to Adam and to Sree - thank you very much for your contribution. And if this is your first Team Talk podcast, you can find previous episodes on Thinking aloud on the abrdn website. And there you can also subscribe to our Fixed Income newsletter. So thank you very much for joining this podcast today. 

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