Analysis | Two Nations Divided by an Uncommon Inflation

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Britannia Rules the Waves (of Rising Prices)

British consumer price inflation is back into double figures for the first time in almost 32 years. Margaret Thatcher was still prime minister when this landmark was last achieved. For the last time retail price inflation was this high, we need to go back even further, to a point when Thatcher, under intense pressure, had famously denied that she was about to execute a U-turn on economic policy. British inflation was last at its current 12.4% in February 1981, the month that Prince Charles announced his engagement to Lady Diana Spencer:

Breaking during a bad-tempered contest for the prime ministership between Rishi Sunak and Liz Truss, confirmation of the severity of the cost of living crisis contributes to a febrile atmosphere. Whoever gets to be premier (probably Truss) will have to take measures to ease the pain for consumers, which will mean using taxpayers’ money to subsidize fuel costs while making clear to everyone that they are committed to fighting inflation. That will mean tight monetary policy. Truss’ talk of changing the Bank of England’s mandate adds to the sense of uncertainty.

The detail of the numbers emphasizes just how painful inflation is going to be for many Britons. Rising energy prices, although extreme, came in slightly below expectations, as this chart from Deutsche Bank AG demonstrates. The problem is in growing prices for services and food:

The numbers for food and non-oil energy, over which monetary policy has limited control, are terrifying and show that this will be an unavoidable political issue:

The data prompted plenty of forecasters to revise their estimates for peak UK inflation up to 13%, and to predict a more hawkish central bank. They also drove a rise in bond yields throughout Europe and the US. This despite evidence from the UK data that global pressures are abating, and that the UK’s problems are now more of its own making. This from Ruth Gregory of Capital Economics:

“There were some signs that global price pressures are easing. Second-hand car price inflation fell for the fourth month in a row from +15.2% to +8.6%. Inflation in this category was initially driven high by red-hot demand and shortages of supply during the pandemic. What’s more, price pressures further up the supply chain eased. Input price inflation dropped from 14.9% in June to 14.6% in July and core producer output prices eased from 14.9% to 14.6%. But there were further signs that the global drivers of inflation are being replaced by domestic ones. Rents inflation increased from 3.2% to 3.8% in July. Moreover, services inflation (which is mostly driven by domestic factors) rose from 5.2% in June to a 30-year high of 5.7% in July.”

It’s hard to see much reason for optimism — except, perhaps, from Britain’s perpetually volatile housing market. The British economy tends to be levered to home prices, and governments will go to great lengths to avoid their decline ahead of a general election. The two times in the last four decades when an incumbent government was defeated — John  Major in 1997 and Gordon Brown in 2010 — both happened after sharp falls in house prices. So it’s perhaps encouraging that the efforts to take the sting out of the housing market may be having some effect. The latest data show a surprising decrease in house price inflation, from a level that was looking dangerously overheated:

The housing price inflation spikes in this chart were all followed by a crash and an economic recession. If the BOE’s moderate tightening to date has at least managed to fend off another bout of mad housing speculation, that will be helpful. But it’s a slender reed to be grasping. 

U-Turn If You Want To. But Is the Fed for Turning?

The release of Federal Open Market Committee minutes doesn’t usually involve a lot of theatrics. They’re published belatedly, three weeks after the Federal Reserve has spoken and in this case many things — including surprisingly strong employment and weak inflation data — have happened since then. But the minutes for the July meeting, released Wednesday afternoon, were interesting because the Fed is trying to take a nuanced position. Bob Miller, BlackRock’s head of Americas Fundamental Fixed Income, wrote:

“The intended message from the Fed was not ‘dovish’ per se, despite the bond and risk asset rallies that followed the meeting date. Rather, we think the intended message was much more nuanced. We believe the intended message was to signal a wider aperture in the Committee’s reaction function, setting the stage to eventually allow time to work for them in pursuit of their policy objectives; a logical transition for the Fed to make at this stage.”

The main takeaway was clear: Officials see the need to eventually dial back the pace of interest-rate hikes but also agreed on the need  to assess how their monetary tightening was working toward curbing US inflation before doing anything that could be called a “pivot” (a word that appears nowhere in the document). US stocks fell for the first time in four days on Wednesday. But in the bond market, two-year yields, highly sensitive to rate changes, dramatically pared their earlier advance after the UK inflation numbers:

This looks like an overreaction as the statement was at best ambiguously dovish. This line in particular left the door open to keep tightening: “In view of the constantly changing nature of the economic environment and the existence of long and variable lags in monetary policy’s effect on the economy, there was also a risk that the committee could tighten the stance of policy by more than necessary to restore price stability.”

The implication was that this is a risk the FOMC is prepared to take. In response, futures contracts lowered the likelihood of a 75-basis-points (as opposed to 50-basis-points) fed funds boost next month to about 40%. Intriguingly, fed funds futures also began to show less confidence that the Fed will start cutting rates early next year, and are more inclined to discount a steady plateau for interest rates rather than a sudden pivot. The following chart shows the implied fed funds rates for next month’s meeting, and for February 2024, as generated by the Bloomberg World Interest Rate Probability service. 

To visualize it a different way, try the following two screen shots from the Bloomberg terminal. This shows the projection for the fed funds rate at each meeting from now until January 2024, as it stood on July 27, the day of the last FOMC meeting:

This shows quite a dramatic pivot. Now, here is the same chart as it appears at the time of writing, after the publication of the minutes of the July 27 meeting:

Confidence in an imminent pivot has reduced in the last three weeks, as the unemployment data would suggest it should. 

“I am not sure these minutes feed into the idea of a policy pivot as much as some of these headlines suggest. Yes, the pace of hikes will slow (you can’t keep going 75) but that does not mean cuts either,” Neil Dutta, head of US economic research at Renaissance Macro Research LLC, wrote. “The minutes also clearly demonstrate the Fed’s hawkish bias is needed for risk management purposes. It is a risk they are willing to take.”

Fed officials even offered themselves some early self-congratulations, said Steven Blitz, chief US economist at TS Lombard. Here’s that part:

“Participants noted that the Committee’s credibility with regard to bringing inflation back to the 2 percent objective, together with its forceful policy actions and communications, had already contributed to a notable tightening of financial conditions that would likely help reduce inflation pressures by restraining aggregate demand.”

In another optimistic tone, the participants also noted signs of gradual improvement in the supply situation and highlighted the improved availability of some key inputs. Here’s Christopher Low, chief economist at FHN Financial:

“There is an inkling of improvement on the supply side of the economy, there is a bit of hope in some product prices moderating, but there is still a great deal of concern about inflation and inflation expectations.”

Jeffrey Roach, chief economist at LPL Financial, noted how the FOMC described the current inflationary environment as fraught with supply and demand imbalances, using this phrase eight times throughout the document. This revealed “a precarious position as the Committee knows its monetary tools do not work on supply shocks,” and he warned: “The markets could interpret this as a Fed impotent against some of the current inflationary fight.” 

Governors also commented on the dollar’s strength as yield differentials widened. Exchange rates are officially a matter for the Treasury rather than the central bank, and this could be taken to mean that the Fed is under increased pressure to keep the greenback from appreciating too much against other countries, especially emerging markets.

For now, investors will have to wait until the Fed officials’ retreat next week in Jackson Hole, Wyoming, where they will have a chance to tweak expectations again. A lot has happened since these minutes were written. Blitz of TS Lombard weighs in again:

“These minutes caught the FOMC at a moment when decelerating data accelerated their confidence that they could soon entertain a slowdown in the pace of rate hikes. They did, however, acknowledge that tighter financial conditions, including a positive real Federal funds rate, were needed to reduce demand for labor and, in turn, bring inflation back to 2%.” 

With equities gaining more than 7% in the three weeks since the Fed wrote, and the real fed funds rate (subtracting the headline rate of consumer price inflation) still at minus 6% (lower than it was a year ago), it’s a good guess that Jerome Powell will feel the need to douse the expectations of a “pivot,” and brace for a tightening campaign that takes the fed funds rate above 3.5%. 

America First

There’s been one trend that has held true ever since the Great Financial Crisis: US equities just keep beating the rest of the world without fail. Nothing — not surging inflation, a credit downgrade, fears of recession or even a once-in-a-century global pandemic — can stop it. 

The following graph shows the ratio between the benchmark S&P 500 and the FTSE All-World Excluding United States Index, which includes large and mid-capitalization firms for developed and emerging markets. The trend is as clear as day:

Zooming in on the quarter to date, the grind upward may have been a bit bumpier, but the S&P 500 has still outperformed. That’s mainly because it bottomed on June 16, according to Nicholas Colas, cofounder of DataTrek Research. That eventful week, he says, also saw the Nasdaq Composite and the Russell 2000 setting their lows on June 16, the 10-year Treasury yields easing from the 2022 highs they set on June 14, and the Federal Reserve announcing the first of two 75-basis-points rate hikes on June 15.

It was almost a full month later before the MSCI EAFE Index, which represents the performance of large and mid-cap securities across 21 developed markets, and the MSCI Emerging Markets Index that captures large and mid-cap representation across 24 emerging markets countries, bottomed on July 14. DataTrek explains the timing further in a note published Tuesday:

“The upshot here is that it took non-US stocks basically a full month to make their Q3 to date lows because currency markets did not reach ‘peak dollar’ at the same time as ‘peak pessimism’ hit US equities.”

Also on July 14, the US dollar peaked year-to-date, rising to 124.1 based on the Fed’s Nominal Dollar Index. Two years ago on March 23, Colas noted that the greenback also hit its high to coincide with the lows for global stocks on the same day. Both are driven by risk appetite, and the peak for the dollar in 2020 and possibly again this year meant that the peak for risk aversion was also in. That then allowed stocks that didn’t benefit from haven flows into the US to begin to perform better:

After Wednesday’s publication of the FOMC minutes, the Bloomberg Dollar Spot Index, a broad gauge of the greenback’s strength, pared back gains. That’s because the market took heart from comments in the minutes that the Fed would need to slow down the pace of interest-rate hikes at some point. Even so, the decline for the dollar was driven almost entirely by the euro — it still climbed relative to its other Group-of-10 peers.(1)

For Peter Boockvar, chief investment officer at Bleakley Financial Group, the dollar’s climb may see its end very soon. “With the likelihood that the Fed slows the pace of its rate hikes to 50 basis points and possibly by 25 basis points thereafter at the same time other central banks keep hiking, the dollar has seen the end of its recent rally, I believe,” he wrote Wednesday.

Still, DataTrek’s Colas maintains he continues to favor US equities over international stocks. “We do not see the customary preconditions for sustained rest of world stock outperformance. EAFE and EM tend to be good early cycle plays as the global economy recovers from recession. We are not in that sort of environment just yet.” It’s not been a great idea to bet on the rest of the world to beat the US stock market for almost 15 years now — and on this argument, it still isn’t.—Isabelle Lee

Survival Tips

Every so often, there’s a time for schadenfreude. The Red Sox have been lackluster and inconsistent this season, and that’s being kind. They have a poorly constructed team that has occasionally been laughably incompetent at making basic plays.

But never mind. It’s not like we thought they were going to be that good. And there’s always great pleasure to be taken from the misfortunes of others; particularly the New York Yankees. A great (spoof) piece in The Onion reveals the following:

“After observing millions of different scenarios, we have confirmed that seeing the Yankees lose a home game and watching their awful fans sadly file out of the stadium increases dopamine production in the brain to levels unmatched by any other event,” said Professor Andrew Lau, a co-author of the Stanford University study, which found the average level of joy derived from seeing the Yankees lose a ball game surpassed that of watching one’s child be born, one’s wedding day, or winning the lottery.”

That sounds about right. In other sports, a stinging defeat for Manchester United or the Dallas Cowboys is almost as good. But discomfiture for the Yankees is particularly enjoyable. Barely a month ago, they were on track for the best season ever. But since then, they’ve lost two thirds of their games, and they seem to have forgotten how to hit, pitch, field, or — most hilariously — run the bases. 

OK, they’re still way ahead of the Red Sox. I thought it was a good idea to indulge now rather than wait for their inevitable late-season resurgence. For now, life is good, and the Yankees are bad. If times are tough, you can always take pleasure in the misery of others. (And, as I write, the Yankees have just won 8-7 with the aid of a walkoff grand slam in the bottom of the 10th, so I’m glad I enjoyed their disquiet while it lasted.)More From Other Writers at Bloomberg Opinion:

• Jonathan Levin: Fed Shouldn’t Get Baited by Vigilante Stock Traders

• Hal Brands: Russia’s War in Ukraine Is How the Soviet Union Finally Ends

• Andrea Felsted: Target’s Having a Much Harder Time Than Walmart

(1) The Australian, Canadian and New Zealand dollars, the euro, Japanese yen, British pound, Norwegian krone, Swedish krona and Swiss franc.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”

More stories like this are available on bloomberg.com/opinion

©2022 Bloomberg L.P.

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