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As much as central banks would like us to believe that they have a handle on inflation, I just don’t see that being the case.
Of course, central banks are there to manage monetary policy, and perhaps more importantly, to manage expectations. Think about it. The last thing they want is for us to expect that inflation is going to stay high, because that would mean high interest rates for the longer term. Businesses would pull in their horns, downsize or even cancel expansion projects, and perhaps even shrink their operations thanks to elevated costs. Home buyers would put off buying on the assumption that carrying costs will just become too high.
So the Fed, along with its cohorts from other nations, wants us to buy the narrative that they will achieve their 2% inflation target within a reasonable amount of time, perhaps 12-18 months. I don’t buy it. In fact, I think that we should get used to at least 4% as a new longer term inflation rate. That would actually work in the governments’ favour. Remember, western nations carry historically high debt. The US debt level is currently 130% of GDP. In the 1970s, it was more like 35%. Naturally, it was much easier for Volcker to raise rates in the late 1970s to 20%, as the interest payments for governments was on relatively much lower debt levels. Raising rates to just 7%-8% today would crush the economy and wreak havoc across nearly all sectors, but especially real estate. Let’s say the Fed stops raising rates, then starts lowering and stops around 2.5% - 3%. If inflation stays elevated around 5%, that means ongoing negative real rates of about 2% - 2.5%. That kind of environment helps government, saddled with massive and growing debts, inflate away its obligation as negative rates lessen the burden of repayment.
That’s why I keep saying that 4% will be the new 2%.
For the Fed to get inflation back to 2% will be a near impossible task, in my view. Let’s see. The Fed funds rate is already at 4.5% - 4.75%. Current expectations are that it will peak at 5.5%.
And yet current inflation is at 6.4% for January, above the expected 6.2%. Canada’s inflation is at 5.9%, while in Europe it’s a lofty 8.5%. The latest US inflation numbers saw shelter up 7.9%, energy gained 8.7%, and food was up 10.1%. But these last two are not considered by the Fed, which looks at core inflation and leaves out volatile components.
In the meantime, prices for services, or “service inflation”, as opposed to “goods inflation” has continued rising.
Once the COVID pandemic hit, people stayed home and consumed things: food (not at restaurants), alcohol, electronics (computers, tablets), and they spent on home renovations and improvements as they weren’t traveling. Naturally, prices for goods surged as supply chains were chaotic, plus energy in the past year got a sudden boost as Russia invaded Ukraine, limiting oil and natural gas exports. That war also caused a dramatic reduction in farming, fertilizers, and chemicals from the area. These shortages lit a fire under prices for goods of all kinds.
Fast-forward to today, and as COVID is retreating, people are shifting back towards consuming services. That means renewed demand for travel, flights, hotels, entertainment at public venues, spas, restaurants, and even things like car insurance.
So it probably won’t surprise you to know that the 1-year forward inflation expectations in the US are at 5%.
That’s high, and well beyond the Fed’s ultimate official target of 2%. If 5% is still the norm 1 year from now with current rate hikes, how long will it take before we reach 2%? I just don’t see that happening for a long, long time.
The bond market is a very smart market overall, smarter than the stock market, and much bigger. Maybe it’s because its participants, the successful ones, are better at knowing history. Either way, look at where 1-year US Treasuries stand.
Not only is the 1-year Treasury yielding +5%, it’s been rising over the past month. That tells me the 1-year inflation expectations are probably quite reasonable.
The Atlanta Fed calculates a “Sticky-Price” CPI (Consumer Price Index). It’s essentially a basket of items whose price changes slowly over time.
Interestingly, this has only been heading higher since its August 2021 low, and has not retreated since. That suggests even items whose prices change slowly continue to trend steadily higher.
It’s also worth noting that the US Bureau of Labor Statistics recently changed its method for calculating the CPI. Calculations will now change spending weights for different items based on a single year of spending patterns. Prior it was a two-year blend. The bottom line is that will likely suggest that inflation is cooling faster, especially as we calculate year-over-year levels in the wake of very high prices. Keep this in mind as we move forward. I think this is meant to make inflation appear more benign. The fact that we are gearing up for a US election next year (yes, already) is no accident. That’s all in an effort to improve the incumbent’s chances at re-election.
Despite this, I expect inflation to remain elevated. Most people I know don’t feel their daily living costs reflect official numbers.
In addition, the overarching forces of commodity scarcity, the ongoing war-premium, and the green transition will underpin inflation pressures.
That’s why I say that 4% inflation will be the new 2%. And that suits central planners just fine.
And it’s why precious metals should continue to be the cornerstone of investment portfolios going forward.
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