Inflation eases, but challenges loom

The US Federal Reserve announced its first cut in interest rates in four years today, the strongest indication yet that inflation has been vanquished. Inflation is now at or near central bank targets across the major economies. Perhaps it was transitory after all, it just took a little while to fall. But can investors really stop worrying about it?

The most recent set of inflation figures from the US gave some pause for thought.

US core inflation, which excludes volatile energy and food prices, was higher than expected for August, rising 0.3% month on month, against expectations of a rise of 0.2%. While broader inflation still trended lower, core inflation tends to be the focus for policymakers and this latest reading may spook the Federal Reserve into limiting its upcoming rate cut to 25bps, rather than the 50bps hoped for by the market.

This chimes with warnings over the problem of ‘last mile’ inflation. This economic theory suggests inflation declines quickly from its highs, but there tends to be stubborn, residual inflation, which is far more difficult to get out of the system. Federal Reserve Chairman Jerome Powell once admitted, “as you get further and further from those highs [in terms of inflation], it may actually take longer time.”

Has inflation been tamed?

Nevertheless, there are plenty of fund managers who believe that inflation is tamed. Their view is that growth is relatively weak, debt is high, and the proof is in the statistics. Ariel Bezalel, manager of the Jupiter Strategic Bond fund says: “We believe the path of disinflation has resumed. Non-seasonally adjusted month-on-month numbers for US Core CPI since October 2022 show that monthly inflation has come below the same figure reported a year earlier in almost all the months, except for a few exceptions. The usual drivers of inflation have also been largely absent over the past two years, with money supply growth non-existent across major developed markets and commodity and food prices softening.”

He points to a weakening US jobs market and declining consumption, adding: “Estimates of excess savings, low savings rate, elevated volume of consumer credit, lower income expectations and stagnating retails sales are all showing signs of slowdown”. Manufacturing data is also slowing, which is exerting a drag on the economy.

This should be good news for those waiting for further rate cuts from central banks. Ariel’s view is that real interest rates look too high and there is a risk that central banks have to ease even faster than currently priced. He adds: “That could provide a fillip to fixed income markets, particularly the high-quality segments of the asset class.”

Jason Borbora-Sheen, manager of the Ninety One Diversified Income fund, takes a similar view, believing that inflation may turn out to have been driven by transitory factors from Covid: “Initially the Fed had the view that was the case. They moved away from it quite swiftly, and acted fairly ardently to get inflation under control…Now we are closing in on target for many of the large central banks of the world.”

He says that short-term spikes in inflation are usually caused by temporary factors. He points to some problems in the UK, where measurement of inflation tends to be less accurate. In the US, he says, he continues to see some “pretty heartening” data. His view is that the Federal Reserve is starting to shift from its focus on inflation to a focus on employment. “When you look at various measures of where policy should be relative to those two objectives, the US is too tight and it didn’t make sense for them to sit back and wait to cut.”

But for how long?

On the opposite side of the argument is Nick Langley, manager of FTF ClearBridge Global Infrastructure Income, who sees ongoing inflationary pressures from a number of structural changes in the global economy. He says: “As we look forward, governments have got to spend massively to decarbonise their economies. The energy transition is going to mean more expensive electricity for the next 10-20 years. Energy is an input into everything, so will drive costs higher.

“We’re also going to have a range of supply chain bottlenecks across our economies as we start spending a lot more on defence, or as we start spending more on data centres and similar infrastructure. Re-shoring a lot of manufacturing capacity to realign supply chains to our friends and neighbours is likely to mean more expensive goods.”

He adds that one of the things that has led to low inflation over the past few years has been the rise of China, which has created goods at lower and lower prices. He believes the world is “bumping up against the limits” of how much it is willing to buy from China and this source of deflation will end. The ageing cohort of boomers may drive services inflation. “When you layer those things on top of each other, we are going to be in a higher inflation environment.”

Another rogue factor could be a Trump presidency in November. Trump has said he will bring in 10% tariffs on everything, and even higher from ‘unfriendly’ nations, such as China or Mexico. He also wants to restrict migration, which will put upward pressure on wages and weaken the US Dollar, which would also be inflationary. Nick points to broker estimates that these policies could add as much 1.5% to US inflation.

It may be that both sides are right. Inflation is tamed for the time being, but there are pressures that could revive in the longer term. At the very least, inflation may be bumpier from here and the paths of different countries may diverge. Investors should always worry a little about inflation and the current environment is no exception.