Settling into a higher inflation world

It might be peak economic complacency, but the world seems to be settling into a period of “medium high” inflation.  To be clear, I am not talking about a 1970s style inflation explosion, or a Venezuelan hyperinflation, but rather a period where inflation persistently runs at 3% or 4% rather than nicely in the 2-3% target RBA band.

The key driver of this is that both Australian and the US share the following economic conditions:

• Unemployment is low – that is, employees seeking a wage rise have high confidence of being able to find an alternative job  

• Historic inflation is high – that is, wages have fallen in real terms and, hence, workers are motivated to seek higher wages;  and

• Economic growth is positive, and businesses seem, in the main, able to push through cost-based price rises.

  
  

In this environment, wages are likely to keep growing reasonably strongly.  For example, the chart below shows nominal wage growth in the US over the last decade.  Pre Covid, wage growth was typically 2-3%.  Since, while decelerating in 2024, it has still been running at 4-5%.

Once you have wages growing at 4-5%, the maths for inflation is pretty simple.  For the services component of inflation – where the biggest cost input is wages – inflation is going to grow at wages less productivity growth.   The chart below shows tradeables (eg basically goods) vs non-tradeables (eg basically services) over the past 10 years.  Pre Covid, non-tradeables inflation was basically equal to wage growth (ie not much productivity).  Post Covid, wages have being playing catchup with prices.   It is also important to note that non-tradeables inflation has been significantly suppressed (around 0.8%) by the state and federal electricity bill rebates.  On an underlying basis, services inflation is running at more like 5%.

If you take 4-5% wage growth as a given and optimistically assume 1% productivity growth (ie much better than recent history), then this is likely to spit out 3-4% inflation growth.  It is possible that goods inflation can deduct from overall inflation – such is the case at the moment – but if Trump is true to his word on tariffs it is hard to see goods detracting from inflation going forward.

In the US in particular, it is quite possible that headline inflation troughed in Q3 2024 and will re-accelerate from here.

What does this mean for investors?

The first implication of 3-4% inflation is that it is pretty tough environment for government bonds.  The market is already pricing this in, with US 10 year bond rates back up near the top end of their recent trading range.

The second implication is that a high inflation environment favours real assets (eg equities, infrastructure, commodities and property) over nominal assets (cash and bonds).  This is reflected in markets, with US equities near all-time highs.

Third, high inflation is good for credit.  That is, in a high inflation environment businesses cash flows are growing relative to their nominal debts and so defaults tend to be below average.  Again, this is priced in by markets, with credit spreads relatively tight compared to their long-term averages.

Finally, investors seem to be banking on further rate cuts in the US in 2025 and the start of rate cuts in Australia.  For example, forward curves in Australian and the US predict an average of couple of rate cuts in 2025.  If inflation proves stubbornly high – or re-accelerates – these cuts may not materialise.