The 2nd Coming of Inflation

It May Have Already Started

This week, the U.S. CPI report showed that inflation came in slightly higher than expected, reversing a recent trend of lower and below forecast readings. One number doesn’t in and of itself indicate a broader change of conditions, but it should serve as a reminder that the path to monetary easing isn’t locked in.

Yes, inflation is contained for the time being, but assuming that we’re on an eventual path towards the Fed’s 2% target isn’t a certainty. In fact, there are a number of things happening as we speak that would indicate that inflation could become a big problem yet again.

Let’s first take a look at the U.S. core inflation rates over the past year.

Core inflation had been trending lower throughout the past year. It bottomed in July and August, but ticked unexpectedly higher in September. Now, this is a 0.1% increase and is just one month, but this could be an important signal. Core inflation has been sticky ever since 2022. Also consider that the month-over-month readings for both August and September were 0.3%, which would work out to nearly 4% annualized. With rent and services inflation also running at nearly a 5% rate.

The inflation problem simply isn’t going away.

The biggest problem for the economy currently is that planned global liquidity additions from both the Fed and the PBoC support higher inflation, not lower inflation.

We don’t yet understand the composition and depth of the Chinese stimulus measures. At the initial announcement, they discussed rate cuts, lower mortgage rates and various measures of support for the real estate and stock markets. There haven’t been a great deal of specifics up to this point, but it sounds like we may get more soon.

The lack of clarity is what’s caused Chinese stocks to become so volatile over the past couple weeks, although they seem to have steadied themselves somewhat in recent days. Regardless, the implication of a massive Chinese stimulus bomb is clear (if it works). Increased consumer spending, increased manufacturing activity and what could be a potential bottom in the housing market.

But that comes with the risk of higher inflation. In the United States, the situation is similar. The Fed has already cut rates once and it will likely do it several more times before the end of 2025. Plus, the Fed has also indicated increased liquidity through bond issuance and other lines of credit in the 4th quarter. Higher liquidity usually means good things for risk asset prices, but it also means longer-term inflationary pressures.

In short, the markets may be celebrating the idea of lower interest rates and lots of stimulus, but they’re underestimating the risk that comes with a second bout of inflation.

Several asset classes are also giving signals that they’re worried about the same thing.

Why don’t we start with rates on the middle to long end of the yield curve. Treasury bill yields have fallen in accordance with what the Fed plans on doing over the next 12 months or so, but longer-term yields are doing something different.