For months prices have been rising as the U.S. economy has recovered from the COVID pandemic while financial markets have stayed priced for perfection and central banks have clung to the view that elevated inflation would likely subside in short order.
Now, fears about higher prices are coming to the fore, with BofA Global Research analysts declaring in a Friday note that “stagflation is here” and a government report showing U.S. inflation still at a 30-year high as of August. Even central bankers appeared to be starting to capitulate this week, with Federal Reserve Chairman Jerome Powell saying that high inflation could run into 2022.
Rather than dissipating, price pressures are holding consistently firm and could be getting harder to dislodge as time goes on. At the moment, a global energy shortage is also unfolding across the U.K., Europe and China, shaking up investors previously distracted by COVID’s delta variant, the troubles of China’s Evergrande Group HK:3333, and the potential for a U.S. government shutdown along with the debt-ceiling debate.
Interestingly, inflation fears haven’t yet translated into sustained financial-market action, with bond and stock investors brushing aside Friday’s inflation data and the U.S. Dollar Index
falling, after the past week’s sharp rise in yields, a stock-market selloff and advance in the dollar. On Friday, the Dow Jones Industrial Average
and Nasdaq Composite
indexes were heading higher, while Treasury yields were little changed from the two- to 10-year rate, which was trading around 1.48%.
But the recent, somewhat delayed reaction to the Fed’s hawkish pivot on Sept. 22 offers a glimpse of what might be still come: Treasury yields rose to the highest in months, stocks fell, and the dollar index soared to a roughly one-year high.
“This is the first week that markets realized that global growth could be weak and inflation more persistent,” Athanasios Vamvakidis, BofA’s global head of G10 FX strategy, said via phone from London. “Energy-price increases were a wake-up call for markets, and the scenario that’s now more likely to develop is one in which we get higher inflation and weaker output.”
He sees the prospect of more “pronounced” financial market moves in 2022 than those of the past week. His view is that stagflation is unfolding worldwide, but becoming more severe in the U.S. which could prompt policy makers to tighten monetary policy more aggressively than expected.
Stagflation is a word that conjures up images of 1970’s era double-digit inflation and long gasoline lines, so analysts have been loathe to use it. It’s a scenario that’s basically the worst of all worlds for the average person because it causes real incomes to stagnate or decline while destroying purchasing power.
The scenario currently being articulated by various banks like BofA is more of a stagflation-lite outcome, where inflation doesn’t need to necessarily shoot up much higher from here but lingers for far longer than previously thought.
Vamvakidis says he envisions a scenario where U.S. inflation keeps surprising to the upside and economic growth surprises to the downside, relative to expectations. The core PCE index could stay above 3% into 2022, he says, leaving inflation high enough that the Fed and other central banks might need to tighten monetary policy more than expected at a time when output is weaker and risk asset prices may be volatile. Meanwhile, analysts at Capital Economics in London see an era of higher inflation in the U.S. that lasts for a decade.
“We could easily see inflation at 3% to 4% for a while,” said Gang Hu, managing partner of New York hedge fund WinShore Capital Partners, who trades global inflation-protected securities. “We are not at the end of this supply-side destruction and are entering a period where nobody knows what transitory inflation means.”
“Once this episode passes, I don’t rule out a chance of a prolonged period of deflation” as policy makers “overshoot on the other side,” Hu told MarketWatch Friday. “For now, the market has not lost its confidence in the central bank’s ability to control inflation.”