St Jay and the inflation dragon

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15 February 2024

Global investors now seem absolutely convinced that St George – or rather St Jay, Federal Reserve (Fed) Chair Jerome Powell – has slain the inflation dragon. The S&P 500 has risen 20% from its October low and has hit an all-time high this month.

The exact timing may vary, depending on the latest economic data release, but markets are now pricing in multiple interest rate cuts this year. The ‘Fed put’ is back. With inflation yesterday’s problem, central banks are once again free to cut rates aggressively if growth deteriorates, or so the latest narrative goes. Cause for celebration indeed: equities and bonds will protect each other again and welcome back ‘Goldilocks’.

But could this celebration be premature? Can we really be confident that inflation will return to the 2% target – and stay there?

Yes, headline inflation has fallen significantly from the painful highs of 2022 as food and energy costs have abated and post-covid supply chain disruptions have improved.

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But, as this month’s chart shows, core inflation, one of the measures central banks like to focus on, is proving more persistent. A gap has opened up between the two that looks more reminiscent of the 1980s than the ‘Goldilocks’ era of 2000-2020.

The fly in the ointment here is wage inflation, still running at over double the 2% inflation target in the US and the EU and at over 6% in the UK. Add to that January’s surprise US payrolls report, showing almost two times more new jobs being created than forecast, and it is going to take a lot of productivity growth to get inflation sustainably down to 2%.

At the same time, the backdrop of de-globalisation, geopolitical pressure points and the increasing costs of climate change hardly looks helpful. Tensions in the Middle East remain high and freight costs have now risen to more than double the post-covid low in October last year.

Given all these factors, the last mile in getting inflation back to target, and keeping it there, could turn out to be a lot more difficult than markets currently believe.

If inflation remains sticky, then either current market assumptions on interest rate cuts this year are over-optimistic or central banks run the risk of repeating the error of the 1970s, when premature rate cuts let inflation back in. Furthermore, it would mean goodbye to the Fed put, with the central banks facing far more difficult choices if growth should falter.

We think there is a real risk that we find ourselves in a new regime where 2% represents the floor for inflation, not the average. A world where higher and more volatile inflation makes it far tougher to justify current equity valuations.

This could make inflation-linked bonds rather interesting – especially in the UK, where the long-dated versions are touching the record lows we saw during the UK gilt crisis in September 2022. If central bankers have really vanquished the inflation dragon, then yields look too high. If core inflation and wages are a better guide and the dragon lives on, then inflation expectations and breakevens could finally be shaken out of their complacency and start to rise. Either scenario could be good for linkers.

#inflation

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Piers Wheeler

Director – Institutional

T +44 (0)20 7963 8258

Developing and executing asset management strategy for capital raising and strategic relationship management. Coverage includes EMEA, Asia and Australia. Piers joined Ruffer in 2021, having previously worked with asset management firms including Eastspring, AMP Capital and LEK as a strategic consultant. He holds a MA from the Bayes Business School and a BA (Hons) from the University of Oxford.

Annabel Paterson

Senior Associate – Institutional

T +44 (0)20 7963 8123

Joined Ruffer in 2021, having graduated with a first class honours degree in land economics from the University of Cambridge. After two years working with the UK Private Wealth team and completing her IMC and CFA Level I qualifications, she now supports Ruffer’s global business development and client servicing efforts.

Articles by Annabel

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