The risk of an inflation surprise

Inflation surprises are one of our investment themes.

When assessing the macroeconomic landscape we believe that dovish central banks are likely to be supportive for growth but this could translate into inflation surprising to the upside.

Labour markets are tight in all major developed economies, with the unemployment rate often at multi-decade lows.

In the past, this would typically have led to wage growth and eventually higher inflation, as measured by the consumer price index. This time around, the relationship between low unemployment and wage growth has been weaker.

Some of the explanations for this are more use of technology, the increasing share of the “gig” economy or the lack of bargaining power for workers.

All of these explanations certainly play a role but we think there is a risk that the low unemployment level ultimately pushes wages higher.

Oil matters for inflation

In addition to labour markets, another factor that we highlighted as a risk for inflation is the oil price. There is a distinction in some inflation measurements to correct for a large swing in energy prices which can be volatile.

While headline inflation includes oil and food price changes in addition to shifts in the cost of goods and services, core inflation solely focuses on price changes stemming from the movement in cost of goods and services.

Despite this distinction, an increase in the oil price also influences core inflation through secondary channels. There are many products that include oil prices in their production process and this ultimately leads to a relatively close relationship between core inflation and the oil price.

Supply constraints push the oil price higher

The oil price peaked above $75 per barrel in October last year, before collapsing to below $45 per barrel in December. This had a deflationary impact on prices. However, a conjunction of supply restrain from the Organisation of the Petroleum Exporting Countries and Russia, unexpected supply constraint in Venezuela and Libya, lower than expected output from shale oil fields in the US and a rebound in demand as economic growth picked up all contributed to the oil price rising by more than 50% since its low in December.

Furthermore, the toughening of US sanctions on Iran, meaning the US will not renew in May the waivers it issued for eight countries to import oil from Iran, is likely to tighten supply further. This may be despite commitments from Saudi Arabia and the United Arab Emirates to step up their output to fill the gap.

The oil price is still slightly below where it was a year ago, hence still moderating overall year-on-year price changes. However, it might soon start to be a positive contributor to inflation, adding one more factor to a potential inflation surprise.

In any case, the consensus was not for the oil price to rise as fast and as high as it already has and this is another factor to take into consideration. We continue to see opportunities in US inflation-linked bonds as well as in gold. With central banks taking a decisively dovish stance, inflation surprises could push real yields lower. The effect would be positive for gold prices.

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