It's all about supply (chains) and demand (destruction)

In what has been a perfect storm for inflation, global economies have experienced a once in a generation spending impulse of fiscal, monetary and central bank stimulus that put money directly into consumers’ pockets, who had nothing else to do but to spend on goods, rather than services (services is usually 65% of GDP). Throw in issues with supply chains, a war to drive global energy and food prices higher, and the consumer has seen inflation spike to levels not seen in over 40 years.

The question is often asked by investors: What can central banks do when the problem is on the supply side (supply chains) and the cost of energy?

The answer is clearly to take away the proverbial punch bowl by destroying demand, allowing the supply constraints to heal in time. No more extraordinary fiscal support, no more loose monetary policy and an unwinding of central bank balance sheet liquidity to lower asset prices and thus temper demand.

And the tide is turning. Data prints and market pricing are starting to exhibit signs that the peak in inflation may have been seen in the past couple of US CPI prints. Inflation is a rate of change function − prices need to continue increasing at sustained percentages higher to hold an inflation rate constant. A good example is oil prices. Oil from $40 a barrel to $80 a barrel is 100% inflationary. Thereafter, in the next recorded data period, oil from $80 to $120 is only 50% inflationary. Then if oil started the observation period at $120 and finishes that observation window at $120, it is 0% inflationary. The rate of change in many prices is now slowing. 

That doesn’t mean they aren’t expensive – filling up your car on a Saturday is still eye opening, but the recorded inflation is moderating as a rate of change.

With the US Federal Reserve no longer buying inflation linked bonds as part of its QE program, the US 10y TIPS market has underperformed lower by 40 basis points from its highs of April, now expecting an average inflation rate of around 2.63% over the next 10 years.