Three Risks to the Inflation Narrative

Market expectations of rapid disinflation and a soft landing remain.

January has given a few new risks to the optimistic estimates of disinflation with no impact on the economy.

The first risk comes from the commodity complex and freight costs. Market participants have all but ignored the spread of geopolitical risk and assumed the extraordinary and counterintuitive decline in commodity prices in 2023 as something permanent. However, January has shocked analysts with a dramatic increase in freight costs and a significant bounce in oil prices. Furthermore, the December inflation figures in the eurozone proved that the base effect was an uncomfortably large driver of the consumer price index annual decline in November. In fact, all the components published by Eurostat in the December advance came significantly above the European Central Bank target.

The second risk comes from the significant bounce in net liquidity and effective money supply both in the United States and the euro area. Thus, the following three months will be critical to understanding the real disinflation process and whether market estimates are too optimistic. Unless the money supply declines again, the path to reaching 2% inflation may be challenging. The FOMC minutes came as a surprise to many when, like the ECB, members maintained their commitment to wait and see more than implementing immediate rate cuts.

We have been discussing too much about rate cuts and too little about net liquidity, sometimes forgetting that rising net liquidity has driven markets higher in the fourth quarter, and the first quarter will likely be more challenging considering the estimated volatility in the reverse repo figures. Additionally, massive deficit spending by the U.S. government may keep inflationary pressures above the level that broad and base money reductions would suggest.

The third risk comes from the inflationary impact of government protectionism. As trade barriers continue to build, the monetary disinflation process may be decelerating due to governments implementing trade wars, barriers to commerce, and tariffs. Unfortunately, governments in the euro area and the United States are tightening protectionist measures disguised sometimes as “environmental policies,” making competition more challenging and prices of food and shelter more expensive, by slashing access to land and farming as well as limiting building projects. Interventionism and trade wars make goods and services more expensive for citizens by placing a floor on prices even when monetary aggregates decline.

Food, commodities, and real estate inflation are all monetary effects. More units of newly created currency are going to relatively scarce assets. At the same time, deficit spending and the rising weight of government in the economy reduce the positive effects of monetary contraction and certainly decelerate the disinflation process. However, all those negative effects combined also contribute to the risk of a hard landing, especially when the U.S. and Europe are already in a private sector recession.

We need to be careful with excessive optimism about inflation and even more aware of the perils of expecting disinflation with no economic harm. Many market participants are suddenly surprised that January has started with a negative trend, but this is explained by the excessive expectations of aggressive and immediate rate cuts.