The return of inflation

US rates: heading higher

US interest rates are heading higher. Futures markets show the Fed Funds rate above 2% by the end of 2022 and levelling out at 3.25% in mid-2023. To reach that terminal level, the Fed would need to raise the rate by 25bp at each of the next 11 policy meetings. That progression would be slower than the market expects, leading some to suggest that one or more of the rate increases could be 50 not 25 basis points.

The main reason for the expected rise is that US inflation has already risen sharply and could well rise further. Consumer price inflation was 7.9% in February, the highest rate since 1982, and will likely be pushed higher as a result of recent energy and commodity price rises.

Of course, it is hard to reconcile a 2% policy interest rate and an inflation rate nearing 10%. Policymakers, not just in the US, but around the world have explained this apparently anomalous situation by describing high inflation as likely to be temporary or transient. We have sympathy with that view, but there is no doubt that inflation has remained at an elevated level for much longer than many expected. Temporarily higher inflation after extraordinary events has been a feature of the past. Inflation does not generally rise to a new, higher level and stay there: it tends to subside quite quickly.

A return to 1970s-style inflation?

However, two aspects distinguish the current US inflation experience. First, inflation in the US is higher than in other developed economies. One explanation is that this is due to a much stronger fiscal response to Covid in the US than in other economies. Others see excess US money growth as the fundamental reason.

Second, it has arisen as the confluence of all three of the main pressures that have driven inflation higher in the past. Pent-up demand as consumer spending has recovered, similar to the inflation which followed World War 2; global supply chain difficulties, often as a result of war; and now higher oil and commodity prices, similar to the oil shocks of the 1970s.

Those oil shocks were also accompanied by stagnant growth – stagflation. There is clearly a risk of that recurring but the likelihood and severity are hard to gauge. Much depends on the Russia-Ukraine war: whether it is protracted, if a speedy conclusion can be reached or, indeed, whether there is a further escalation. One broad scenario we have considered is that there is a shock to global supply which reduces GDP growth and raises CPI inflation in the OECD area, both by about 2%. To discover more about our economic and market views, access the full Quarterly Market Review here.