Weekly Brief: Central Banks Keep Wishing On Tomorrow, But Inflation’s Got Other Plans

Weekly Brief: Central Banks Keep Wishing On Tomorrow, But Inflation’s Got Other Plans

over 2 years ago3 mins

Inflation is looking less and less transitory by the day, as central banks keep hoping it'll slip away sometime soon.

🕰 Recap

  • Less than two months ago, the OECD – a major economic organization – said that inflation is here to stay for the next two years
  • The British central bank said last week that it expects inflation to hit 5% by April next year, up from 3% today
  • And data out earlier this week showed US inflation hitting its highest level in over thirty years

✍️ Connecting The Dots

Skyrocketing energy prices, supply chain bottlenecks, and labor shortages have all conspired to push up the rate of inflation across the developed world. In fact, the Bank of England admitted just last week that it’s expecting inflation to hit 5% by April next year. That’s big: over the past three decades, there’s only been three instances where inflation was 5% or higher. Plus, data out this week showed that US prices of goods and services rose by 6.2% last month versus the same time last year – the fastest annual rise in over thirty years.

For now though, central banks are sticking to their guns, claiming that inflation is just “transitory” due to temporary issues caused by the pandemic and the subsequent recovery. But inflation is looking increasingly less transitory. Six months ago, we saw extreme blips in the prices of goods directly affected by the pandemic, like fuel and cars. And now those effects are waning, sure, but broader gauges of prices are surging. For example, the Cleveland Fed publishes a “trimmed mean” of inflation that excludes the biggest outlier components. And this measure – which is particularly popular with economists – jumped to its highest level in three decades last month.

Earlier this year, central banks put forward another argument: that the high inflation numbers are distorted because of the “base effect”, meaning the low level of prices last year (due to pandemic shutdowns) led to elevated year-on-year inflation readings. And so they proposed looking at inflation measured over 24 months instead. But not only has this measure of inflation steadily crept up over the past five months, it’s also just hit its highest level since the global financial crisis. So it seems no matter how you dissect it, inflation is looking increasingly like it’s here to stay…

🥡 Takeaways

1. Central banks have a tricky decision to make.

At least a tight labor market has got wages rising – problem is, they’re not increasing fast enough to keep up with inflation. That means employees’ real wages – that is, their earnings adjusted for inflation – are actually declining, denting people’s spending power. That’s bad news for most developed countries: consumer spending is by far the largest driver of their economies, so an inflation-driven dent in spending can lead to weaker economic growth. That means central banks have a conundrum on their hands: they should implement economy-boosting measures when growth is falling, but have to withdraw them when inflation is running too hot.

2. You can adjust your portfolio to survive this environment.

Traditional bonds aren’t faring too well: their fixed, future payments are worth less when the prices of goods and services tick higher. So inflation-linked bonds, whose principal and interest payments rise and fall with the rate of inflation, could be a smarter investment. And if central banks are forced to raise interest rates to cool down inflation, that could cause value stocks to outperform expensive-looking growth stocks. That’s because the latter promise tasty earnings in the future, but higher interest rates reduce the present-day value of those future earnings. There’s also gold – it’s traditionally viewed as an inflation hedge – and cryptocurrencies, which are starting to be viewed by some investors as a potential hedge for times like this.

🎯 Also On Our Radar

Peloton shares tanked 35% last Friday after the at-home exercise equipment maker cut its revenue and subscriber forecasts. Demand is down now that gym-goers can, you know, go back to gyms, and investors are getting worried that other pandemic-boosted stocks might start coming back down to earth now that lockdowns seem to be behind us.

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