The return of inflation – a legitimate fear or stubborn memory?

Although volatility in markets is at a low – as can be seen from the level of the VIX or the “Fear Index” for the US stock market – volatility in market themes could not be higher. At the end of December, there was a broad consensus that the issue of inflation was dead, with the corresponding forecasts of numerous rate cuts for the first half of 2024. Less than two months later and the estimated date of the first cut in rates is being consistently pushed further out, and one poor set of US inflation figures for January has been enough to bring the fear of a renewed spike in prices to the forefront. But is such a fear really justified?

Firstly, let’s take a look at the US figures that have fuelled this return of talk about inflation. These figures were in fact clouded by one-off effects. On the one hand, data for the “owners’ equivalent rent” for residences category was surprising, rising much more steeply than in recent months, despite the fact that rents – to which this component has been closely correlated in the past – is on a confirmed downward trend. This is a statistical inconsistency which will likely be corrected in future figures, but which has a notable impact for the month, accounting for a third of core inflation. On the other hand, US figures were also pushed up by the price of services excluding rent reaccelerating, to a large extent as a result of annual price increases for a good number of services (car and health insurance, medical services, childcare, etc.). This phenomenon is concentrated on the beginning of the year and does not indicate a continuation of this trend. In addition, outside of the US prism, disinflation is continuing apace everywhere else, particularly in Europe, but also for example in Canada.

There is little in the global environment to favour a clear reacceleration in prices. On the supply side, with the exception of recent disruption in the Red Sea, supply chains have returned to normal. The global economy is hardly showing signs of overheating, with China experiencing deflation and several major economies – Germany, Japan and the United Kingdom – in recession. Lastly, on the demand side, although consumer spending remains robust in the US – in contrast to most developed countries – it is not really in a position to accelerate. Wage inflation continues to subside resulting in stagnation in real household income. Available savings are at a low level and the increased take-up of credit is showing its limits, with late credit card repayments continuing to rise.

Although there may be a few blips in the trend to disinflation from month to month, the trend appears firmly intact. Accordingly, worries among certain investors of a return of inflation seem to be driven by still painful memories of recent inflationary spikes rather than justified by fundamentals. The real risk is that the return of inflationary rhetoric pushes central banks into holding their restrictive stance for too long. This situation could be damaging, weakening the timid cyclical recovery that has been emerging over the last few months.

Final version of 23 February 2024 – Enguerrand Artaz, Fund Manager, LFDE