Five reasons why U.S. inflation is likely to worsen
February’s U.S. inflation data dominated headlines last week—a trend that’s likely to continue as the Russia-Ukraine conflict means that price pressures aren’t likely to ease soon.
The U.S. Consumer Price Index (CPI) jumped 7.9% in February from a year ago and core CPI, which strips out energy and food prices, rose 6.4% year over year—levels not seen since the early 1980s. Worryingly, while February was once expected to represent the peak of the current inflation cycle, we’re now unlikely to see that for a few more months as a result of the conflict.
When we studied February’s data, we saw the same dynamics that have been at play throughout the past few months: Services inflation is starting to rise as price pressures become more broad based, but the bulk of price increases continue to be most prominent in COVID-19 distorted areas such as cars and goods.
That said, COVID-19-driven inflation isn’t what worries us. We have had high conviction in our inflation framework and are of the view that this type of inflation should begin to dissipate quickly after February. War-driven inflation, however, is a fundamentally different animal altogether: It’s more nefarious and persistent. As we’ve noted recently, it’s likely to exacerbate and extend the duration of our stagflation base case in the first half of the year and reduce our conviction in a return-to-Goldilocks scenario in the second half of 2022.
U.S. inflation at multi-decade high
We’ve identified five reasons why this new inflation we’re experiencing now is likely to be more problematic than what we’ve seen so far:
1 Increased uncertainty
February was, until quite recently, supposed to be the mathematical peak in COVID-19-driven inflation, but the surge in energy and food prices as a result of the conflict means prices are likely to keep rising until April at least, if not June. Macro visibility is awful at the moment since it’s impossible to know how protracted the conflict will be or how long energy prices will stay elevated. We do know, however, that crude oil prices above the US$110 a barrel mark (specifically, West Texas Intermediate) can be particularly problematic for growth. To complicate matters, history teaches us that energy shocks are ultimately deflationary because of their impact on growth. This means near-term inflation should be modeled higher, but medium-term inflation needs to be modeled lower, making economic modeling much more difficult to the extent it risks being far less reliable.
2 Demand destruction
Arguably, energy and food price inflation has a more prominent impact on everyday life than price surges in second-hand cars and housing inflation. Yes, most of us own a car and all of us need a roof over our heads, but very few among us buy a new car every month, let alone new houses; however, our dependence on food and energy is more or less inelastic. In our view, it’s inevitable a protracted period of elevated food and energy prices will inevitably hurt consumer demand for goods and/or services that are either discretionary or that can be substituted by something cheaper.
"To complicate matters, history teaches us that energy shocks are ultimately deflationary because of their impact on growth."
3 Real wage declines and down sentiment
According to our analysis, in inflation-adjusted terms, wages are already at their worst since 1998 despite recent nominal wage increases.¹ Moreover, wage growth momentum looks as if it might have peaked, implying that real wages could be about to decline further. No wonder consumer sentiment in the United States has continued to decline; the University of Michigan Consumer Sentiment Index, for instance, fell to levels typically seen during recessions in February.
4 A potential return to fiscal support
While the U.S. Federal Reserve (Fed) is behaving as if it’s able to address supply-side-driven inflation, such as port closures with interest-rate hikes, nobody is really expecting central banks to mollify price hikes in energy and food prices arising from military conflict. As such, we’re beginning to hear more about how the role that fiscal policy can play to ring-fence discretionary income (through tax reduction). In other words, we may see increasing pressure to turn to fiscal policy to save the day. That's not a panacea, however, as there will likely be friction on that front given how deficit levels have soared on account of the pandemic—many believe that fiscal conservatism is appropriate.
5 No cover for central bank dovishness
While the Fed is aware that it can’t do much to influence gas and food prices, these massive inflation prints make it near impossible to pivot dovishly until the growth picture starts to worsen and/or signs of weakness in the labor market. Even the European Central Bank—which formulates monetary policy for a region that’s set to be most severely affected by the Russia-Ukraine crisis—kept to its tightening bias and brought forward the pace of its quantitative tightening efforts last week. Indeed, global central banks will need material cover in the form of a clearer deterioration in actual data before they can pivot, which we believe will happen in the latter part of the second quarter.
In our view, investors should brace themselves for official policy rates to move higher—at least in the near term; however, these hikes aren’t likely to do much to ease inflationary pressures. Crucially, investor expectations of the number of rate hikes we’re likely to see this year remain overly aggressive. A dovish pivot, we believe, will be needed soon.
1 Manulife Investment Management, March 10, 2022.
Important disclosures
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.
This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional
Australia: Manulife Investment Management Timberland and Agriculture (Australasia) Pty Ltd, Manulife Investment Management (Hong Kong) Limited. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad 200801033087 (834424-U) Philippines: Manulife Investment Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Manulife Investment Management Timberland and Agriculture Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.
Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.
550976
