Jonathan Gregory
Head of UK Fixed Income

The last resort: Bringing inflation back to target when all else fails

Among the most extraordinary fossils you may see today are those of perfectly preserved prehistoric insects, trapped in amber, millions of years old, but looking uncannily alive. These were formed as sticky and sweet smelling resin oozed from trees, lured unsuspecting creepy-crawlies then hardened and fossilized through time to become amber. Take these fossils in hand today, turn them in the light and you can be convinced a 23 million year old scorpion is about to could crawl into your palm.

But don’t worry, these creatures are perfectly harmless. Unless, that is, you take an alternative and wider view; consider that the premise of 1993 film Jurassic Park was the extraction of DNA in dinosaur blood from prehistoric mosquitoes in fossilized amber.

Thirty-years, six movies and an animated series later I would say that the harm visited on the world’s cultural landscape was rather large. I don’t know exactly how many dinosaur disaster movies the world needs but the Jurassic Park franchise does appear to have left us chronically oversupplied. The fossil record now has a lot to answer for; beautiful, harmless, but potentially dangerous when looked at from an alternative perspective. I can’t help feeling the same way about the path of inflation today.

Inflation threat?

For sure, inflation is trending lower after its peak mid-last year. Chart 1 shows the year-over-year change in US Consumer Price Inflation (CPI) recently dropped to 6.4%, well down from the double digit levels of 2022. Closer examination reveals that energy and other commodity prices have been the main driver of this fall.

Chart 1: US CPI, year-on-year

A combined line and bar graph showing the year-on-year trend of US consumer prices, along with its core constituent parts such as ‘core services’, ‘core goods’, ‘food’ and ‘energy’.

Source: Bloomberg, US Bureau of Labouar Statistics. Data as at 16 February 2023

A combined line and bar graph showing the year-on-year trend of US consumer prices (CPI), along with its core constituent parts such as ‘core services’, ‘core goods’, ‘food’ and ‘energy’. The chart shows CPI increasing significantly from the middle of 2020 until the middle of 2022, and has started falling back since July/August to today.

That is the good news. The story gets more complicated as we get into the details. Chart 1 also shows that services inflation, which now accounts for more than half of the total inflation print, is still rising. Looking at inflation month-over-month (i.e., the most recent momentum in prices) and the headline level actually increased. In December, month-over-month CPI fell by 0.1% which was a very bullish signal for bonds; when headline prices were actually falling then it was easier to see a way back to the 2% inflation target. But January data (Chart 2) shows the trend of falling prices over the last few months has gone into reverse.

Chart 2: US CPI, month-on-month

A combined line and bar graph showing the month-on-month trend of US consumer prices, along with its core constituent parts such as ‘core services’, ‘core goods’, ‘food’ and ‘energy’.

Source: Bloomberg, US Bureau of Labouar Statistics. Data as at 16 February 2023

A combined line and bar graph showing the month-on-month trend of US consumer prices, along with its core constituent parts such as ‘core services’, ‘core goods’, ‘food’ and ‘energy’. The more recent and granular CPI chart shows it actually increasing in recent months.

Now, there might be several good reasons why none of this matters; inflation is a lagging indicator after all and the full effect of the 4.5% increase in US policy rates over the last 12 months is yet to be felt. There were also some technical changes to the calculation of the US inflation basket in January that cloud the picture a little. So perhaps January is just a blip and peak inflation is definitely behind us. This is still our base case.

A series of ‘what ifs’

But this might also be a good moment to think about a few ‘what ifs?’

A pertinent one might be ‘what if the easy inflation battles have been won and things get harder from here?’ Or, the related, ‘what if inflation is sticky at say 3-4%; well below recent peaks but uncomfortably above central bank target?’ Much of the decline in headline inflation around the world reflects the reversal of the energy price shock following Russia’s invasion of Ukraine and post-pandemic easing of supply chain problems affecting some goods prices. But, as we have seen, US services inflation and inflation ex-energy and food are not falling very fast. In which case, what might the long-term consequences be – not just in the US, but globally?

Asking questions like these is the bread-and-butter of good active fund management. They are how we tease out plausible alternative scenarios to the base case and guard against ‘groupthink’.

And they can lead to some interesting discussions.

Since the advent of inflation targeting in the late-1990s almost every major central bank settled on 2% as the ‘right’ target. Although the principle of inflation targeting was relatively easy to explain i.e., price stability allows businesses and households to make better spending and investment decisions – the actual 2% target itself, and why so many banks happened on the same target is something of a mystery (to me, at least). You could even be forgiven for thinking that the number was plucked out of mid-air.1

There is no absolute truth in economics that 2% is the ‘right’ number or meaningfully ‘better’ than say 1% or 3%, and very little (if any) quantitative data or research to justify 2% versus another number. Central banks would, of course, point to the dangers of too high inflation (eroding savings, curtailing investment and so on), or targeting too low a number (risking deflation, households and business deferring spending at the expense of consumption today).2 But 2% as the right number? That is surely as much a political decision as an economic one.

As the art of taxation was once described as plucking the goose to obtain the largest possible amount of feathers with the smallest possible amount of hissing, so the art of inflation targeting might be to persuade everyone that you are protecting them against the evils of deflation but not eroding their savings and spending power too much. Put it this way, 2% annual inflation will erode the value of your savings by about 25% over 10 years. I don’t know any central bank that justifies its policy approach on this platform, preferring instead to major on the themes of ‘low’ and ‘stable’ inflation; but it is the practical reality.

Lifting the target?

Which brings me back to today’s most interesting ‘what if?’. What if inflation is sticky at 3-4% and central banks decide that returning to 2% is too difficult, or the collateral damage of achieving it too high? I don’t know for sure, but one policy option could be to simply lift the inflation targets higher. Now, this is not our base case and, to be clear, no central bank could unilaterally take that decision; the policy mandate and inflation target are bestowed by government overlords (although some central banks choose the numeric definition of ‘price stability’).

But think about it this way: the 2% target came out of mid-air in the first place, so is hardly sacrosanct. And the list of headwinds is growing; the ongoing cost of the green transition, the unresolved war in the Ukraine and likely significant increase in defence budgets globally, some of the forces of globalization shifting into reverse gear and soaring government debt levels. It is easy to see how those same government overlords might conclude higher inflation is the answer, not the problem.

The longer it takes to bring inflation back to target and the more that so-called structural factors impact global inflation, the more it is possible that debate about the merits of 2% will move into the public arena. Some may dismiss the idea out-of-hand, but central bank mandates are in the service of political goals, and these evolve through time. Not every country will approach the problem the same way, and governments will come to different conclusions. But given the ubiquity of the 2% target and the absence of historical or economic reasons why it is the evolutionary apotheosis of policy making, it is reasonable to consider ‘what if’ the target was lifted to 3-4%.

Suspending (dis)belief

If the debate does start to take hold, the early implications for markets are likely to be as welcome as an angry T-rex rampaging down Wall Street. Nominal bond yields would face serious upward pressure (prices would fall) as higher long-term inflation expectations need higher yields to preserve real (after inflation) returns. Yield curves would steepen. But inflation-protected securities like TIPS would probably outperform (one reason why I think TIPS are a good portfolio diversifier against tail-risk today).

Equity markets would face similar challenges. Companies with any inherent pricing power and inflation protection in revenues would do relatively well. But equity valuations driven by profits only expected in a distant future (e.g., some tech stocks) would likely struggle as yields, and therefore discount rates, moved higher.

Alternative assets like real-estate that have inflation-linked rental revenue streams might mitigate some of the losses implied by higher discount rates. Other alternative assets like gold might also perform well as governments effectively chose to devalue fiat currencies by adopting higher inflation targets. But then again several of my colleagues would consider the precious metal to be a prehistoric monetary fossil all of its own.

It is hard to say exactly where it all might lead, and it might never happen, but the inflation story warrants due consideration today so we can assess whether our asset allocation is properly diversified. As savers and investors we must be on our guard against real threats to devalue fiat money wherever they emerge. This never felt necessary when inflation was stuck below target. But the monetary and political calculus is changing. Exploring a journey to seemingly remote but painful world is clichéd movie-making but also good investment discipline. And, after all, this is Bond Bites, not Bond Bouquets.

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