US inflation has fallen back to 2.4 per cent, not far from the Federal Reserve’s target. In Europe, the inflation levels of the largest economies are already well below the 2 per cent target of the Bank of England and the ECB, just as we saw in the years before Covid.
Central bankers have therefore left the door wide open for a significant series of interest rate cuts. However, the underlying picture is completely different from what it was before the largest inflation surge in the past forty years washed away the ultra-loose central bank policy.
Divergence
One of the most striking charts that underscores how the world is no longer as it was before Covid is shown below. It depicts the average and median inflation expectations for the next five to ten years of US consumers, surveyed by the University of Michigan. Take a moment to reflect on the difference between these two statistics.
Source: Blokland Smart Multi-asset fund.
Generally, the average expected inflation rate lies slightly above the median. In other words, the distribution of expectations skews slightly to the right, meaning more respondents expect relatively high inflation than very low levels. Since the outliers in relation to Federal Reserve policy have historically occurred more on the high side, and because central bankers are terrified of deflation, this is no surprise.
Inflation Fear
But the gap between the average and median inflation expectations as it stands now is unprecedented. The median, at 3 per cent, may be slightly on the high side compared to the past 25 years, while the average, at 7.1 per cent, is the highest since the infamous inflation peaks of the 1980s.
This means the distribution has been pulled entirely to the right by more outliers. There are thus more respondents who expect an extraordinarily high level of inflation. A portion of respondents is evidently so shocked by the actual inflation of the past few years that they are anticipating a repeat of such peaks in the next five to ten years.
Different
It seems obvious to me that these people are behaving differently (in terms of investments) than they did before 2020, when their expectations were less extreme. I don’t think these people are still keen on investing in bonds.
It is also a confirmation that central banks are very willing to loosen their monetary policies at an early stage. This undoubtedly fuels inflation fears among US consumers.
Shifting
The chances of us returning to ‘The Way We Were’, the song by Barbra Streisand from the film of the same name, which came to my mind while writing this column and has now become its title, are particularly slim.
In recent years, several structural developments have been set in motion that have also significantly influenced investors’ behaviour. The likelihood of higher and more erratic inflation is one of them. Budget deficits are getting out of hand, and there is little in the way of solutions other than a vague long-term plan about the importance of innovation from Mr ‘Whatever it takes’, incidentally financed by even larger deficits. And with the rush to lower rates already, new erratic moves by central banks seem to be the default option.
A proven recipe for inflation, then. Not now, perhaps not in the next few years, but certainly somewhere on the horizon.
‘Can it be that it was all so simple then?
Or has time rewritten every line?’
(Barbra Streisand - The Way We Were)
Jeroen Blokland analyses striking, current charts on financial markets and macroeconomics in his newsletter The Market Routine. He also manages the Blokland Smart Multi-Asset Fund.