Where's Inflation Heading?

No one knows for certain, but here are some clues.

By
Samuel Park
Director of Fundamental Research, Pacific Life Fund Advisors
By
Edward Sheng
Head of Asset Allocation, Pacific Life Fund Advisors
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Key Takeaways

  • Due to a variety of facts, inflation has remained stubbornly high for more than a year.
  • But recent economic signs may indicate that inflation is headed downward.
  • Those indicators include improving supply chains, lower shipping costs, and a decline in the backlog of orders.
  • Still, wild cards remain that could keep inflation high: the war in Ukraine, COVID shutdowns in China, and record droughts, among others.

As anyone knows who has been to a gas station, grocery store or car dealership over the past year, inflation has remained stubbornly high for over 12 months. And it’s not just a U.S. issue. Double-digit inflation has dented the United Kingdom’s economy, and many other countries have suffered high inflation rates not seen in several decades. Many factors have contributed to the rise in inflation, including COVID-related supply-chain disruptions, the war in Ukraine and record droughts—all have helped trigger a rapid and sustained increase in energy and food prices. So, where’s inflation heading? That’s a question that can’t be answered with any certainty, but there are some clues.

Recently, we noticed some improvements in the supply chain, which may start to ease inflation. To gauge supply-chain conditions, the Federal Reserve Bank of New York created the Global Supply Chain Pressure Index (GSCPI). The index utilizes variables from various transportation and supply-chain indicators related to delivery times, backlogs, and inventory levels. The Fed excludes changes in new orders since they are considered a gauge for demand. The GSCPI covers seven countries, including the U.S., China, Japan, South Korea, Taiwan, and the United Kingdom. Also in the mix is the euro area.

The GSCPI attempts to isolate supply-side challenges and measures pressures that could impact trade, inflation, or other global trends. The index shows how global supply-chain pressures deviate from the mean, with positive numbers indicating above-average problems.

Here’s a look at where the GSCPI stood through July 31, 2022.

Elevated but Easing Global Supply-Chain Pressures
Source: FactSet as of 7/31/22

Prior to the pandemic, the index typically stayed within one standard deviation from the average. However, the index has been highly volatile since the COVID-19 shutdowns. The pandemic, particularly early on, significantly disrupted the global supply chain in the form of labor shortages and order backlogs. It also led to a surge in demand for certain goods, as people bought and ordered goods for their homes, which, in turn, exacerbated the backlog problem. As an example, according to the Marine Exchange of Southern California, the backlog of vessels at the ports of Los Angeles and Long Beach (the largest U.S. container import complex) peaked at more than 100 vessels in January 2022, forcing long delays and shippers to find alternate routes.

GSCPI has shown the global supply-chain pressure has eased over the past several months, although it remains at a historic high. The following section highlights how some of the underlying components of GSCPI have developed.

Transportation costs have lowered after spiking in wake of the pandemic. The Baltic Dry Index, which measures transportation costs for bulk goods, has returned to more normal levels in recent months.

Baltic Dry Index: Shipping Costs for Bulk Goods Normalizing
Source: FactSet as of 9/1/22

In recent months, the backlog of orders has grown at a slower pace, which indicates there may be less congestion at U.S. ports.

ISM Manufacturing PMI: Backlog of Orders Easing
Source: FactSet as of 8/31/22

Additionally, the recent Manufacturing Business Outlook Survey showed that firms have been finally reporting decreases in delivery time in the U.S.

Manufacturing Business Outlook Survey: Current Delivery Time Normalizing
Source: FactSet as of 8/31/22

The decline in transportation costs, backlog of orders, and delivery times has contributed to the decrease in the GSCPI. Absent further disruptions affecting supply chains, companies appear to be working through bottlenecks.

China may be finally opening up after COVID lockdowns shuttered major regions. China’s PMI has indicated the country has been in expansionary territory since June, although its manufacturing activity remains less robust. (PMI above 50 indicates expansion whereas levels below 50 signals contraction.)

China's Purchasing Manager's Index (PMI)
Source: FactSet as of 8/31/22

Additional shocks to global supply chain may be possible if another round of massive lockdowns happen in China. While many other parts of the world have resumed business as usual, China is unlikely to quickly abandon the zero-COVID policy, largely because many elderly people in China have yet to receive vaccinations. And it will take time to deploy treatments and engage in a public messaging about the reduced health risks from vaccinations and therapeutics.

However, we think the risk from new China lockdowns will be much less than previous ones. Factories have dialed back production as orders have shrunk and inventories have risen.

Rising Inventories in the U.S.
Source: FactSet as of 8/31/22

Currently, companies are well-stocked. Although many producers have added to inventories in case of further supply-chain disruptions, the elevated level suggest some of the buildup may be unintended.

There have been clear signs of softening in the economy when it comes to demand for goods. New orders have contracted in June and July, reflecting well-stocked companies.

Moderating New Orders in the U.S.
Source: FactSet as of 8/31/22

Overall, manufacturing activity has been lackluster as spending on merchandise has fallen and consumption patterns have shifted from goods to services.

Demand for Goods vs. Services
Source: FactSet as of 7/31/22

Easing supply-chain pressures have contributed to the recent slowdown in inflation, and we expect improvements in the supply chain will continue to bring inflation down in incoming readings. However, policymakers have been battling sticky inflation with the risk of sparking a significant recession. It’s possible if constraints on supply chains clear up and tighter monetary policy slow demand, price pressures could fall as quickly as they surged. In fact, manufacturers have reported that price pressures may be moderating for producers.

Moderating Prices for Manufacturers
Source: FactSet as of 8/31/22

However, consumer prices have continued to remain high and shown little sign of easing sufficiently to satisfy policymakers. Food and shelter prices have continued to rise and kept consumer inflation relatively high. Uncontrollable factors such as droughts and the war in Ukraine will likely keep food prices elevated, and low supply of homes may keep shelter prices relatively high. This means more rate hikes could be ahead.

Today, both the Fed and the market expect about an additional 100-basis-point hike to the fed funds rate by the yearend. However, whereas the market has anticipated the Fed will start cutting rates in 2023, the Fed has signaled that it will continue tightening monetary policy next year. We believe consumer inflation could remain high for awhile, and it won’t likely settle down to the Fed’s comfort level any time soon. Therefore, we worry that the Fed may overshoot and bring the economy in for a hard landing, as full impact of monetary policy changes traditionally had not shown up until many months later. The Fed may have made a mistake of reacting to inflationary pressures too late; hopefully, they don’t make another one by tightening too much.

Definitions:

The Baltic Dry Index (BDI) is a shipping and trade index created by the London-based Baltic Exchange. It measures changes in the cost of transporting various raw materials, such as coal and steel.

The Global Supply Chain Pressure Index (GSCPI) is a new measurement of supply chain conditions, created by the Federal Reserve Bank of New York.

The Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector, and is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

The views in this commentary are as of the publication date and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. All third-party trademarks referenced belong to their respective owners.

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