As expected by many, conquering inflation is proving to be more difficult than simply implementing a brief period of interest rate increases. Many of the inflationary pressures that were brought on by the pandemic lockdowns have receded, but ‘the last mile’ of bringing inflation back to central bank’s target of 2% is proving sticky and difficult. To do so, further interest rate increases will be required, and it is likely that interest rates will remain elevated for some time to conquer the last mile to 2% and the inflationary mindset that has developed.
Over recent years, inflation has spread from asset inflation in housing, commercial real estate, stock prices, to inflation of goods like food and energy to service and wage inflation. This inflation causes widespread hardship and civil uneasiness bringing with it political pressure.
I think that the 2% inflation target is a mirage and unachievable without a long and meaningful recession, which will be politically difficult at this juncture in time. The pandemic, the shifting of geopolitical alliances, the energy transition and reshoring of manufacturing to North America are all important reasons pointing to inflation remaining higher than before. In many areas, house prices inflated beyond the reach of families which created societal problems, stunting household formation and ultimately consumer demand.
My guess is that central bankers have about one year to make meaningful progress to conquering the last mile to their 2% inflation target. In 12 months, the US will be in the throes of an election that will complicate the US central bank’s policies. Ultimately, I think that central banks will settle on a new level of comfortable inflation that will be somewhat higher than 2%.
Consumer goods inflation has come off nicely from supply-chain problems caused by the pandemic. Declining fuel prices have led the way as the world has mostly sorted out how to live with war induced sanctions on Russia. However, food prices remain elevated as well as service and wage inflation. To bring these down, unemployment will need to rise, causing hardship to those suddenly out of a job.
Russia’s invasion and battering of Ukraine has been somewhat deadlocked and stymied by Ukraine’s stubborn defenses. NATO countries have supplied more modern weapons that will make Russia’s goals harder. Russia’s successes have been in part achieved by the for-hire mercenary armies like the Wagner Group, which recently attempted a coup or protest rally by marching to Moscow. Putin’s rule looks weaker, and he may resort to more desperate actions. We don’t know what is coming now, and it could be Putin’s last mile.
Stock markets had a good first half of 2023 led by technology stocks, especially in the artificial intelligence, referred to as the AI sector. Some of the popular stocks are very highly priced indicating that market participants are following the trends and buying winning stocks regardless of fundamentals or valuations. These signs of speculation are worrisome and indicate an inflationary mindset to me. Central bankers are surely unhappy with these recent developments. Further, the rise in the US stock market indices is quite narrow and concentrated in a relatively small group of companies which, historically, is symptomatic of an unhealthy market.
Central banks have raised rates in a meaningful way, but core inflation remains elevated. As well ‘animal spirits’ are evident in parts of the US stock market and to some degree in residential real estate. The last time I looked, the US central bank’s money supply remains almost five times the size it was in early 2020 at the beginning of the pandemic. With this newly printed money sloshing around it’s no wonder speculative behavior remains.
We don’t know what the next US Presidential cycle will bring in a little over a year, and the US central bankers don’t either, so I’m sure that they would prefer to get interest rate increases and a recession out of the way before then. There is a lot of work left to do to tame sticky core inflation. With the money supply shrinking and further interest rate increases eventually leading to a recession, central bankers might at last wean investors off cheap money and by the same token, reduce speculative behaviors. It will take a lot of determination for central bankers to implement and will likely be met by a chorus of protests as well as market volatility.
The last mile is often the hardest; think about how difficult it is to lose 20 pounds. It’s somewhat easy to lose the first 15 pounds of excess weight but much harder to shed the last 5. The best way to protect wealth in a new era of higher inflation and interest rates is to own quality companies trading at a reasonable valuation. Good businesses, with ample free cash flow being returned to shareholders remain one of the best stores of one’s savings. As always, The Pringle Group at RBC Dominion Securities will do it’s best to protect your interests.
Tony Pringle, CFA
July 5, 2023
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