Could inflation surprise us all and collapse?

Over the past 30 years, I have had the privilege of working alongside some of the world's finest hedge fund managers, witnessing exceptional thinking and trading. People often inquire about the factors that distinguish the very best from the rest.

I believe the answer to this question is multifaceted. However, one common characteristic among the top performers is their approach to evaluating the future. They tend to view the future as a range of probabilities. For instance, during my discussions with one hedge fund manager regarding market trends, he assigns a 30% probability to a deep recession in the US within the next year. Additionally, he allocates a 40% chance to a shallow recession and 30% to tepid-moderate growth. Consequently, he adjusts his investments accordingly. Rather than fixating on a specific outcome, he embraces a probability distribution because he understands that macro events can unfold in unpredictable ways.

This perspective sharply contrasts with many analysts who tend to attach their personal identities to their forecasts. The success or failure of their predictions becomes intertwined with their sense of self-worth. If their forecast turns out to be accurate, they proudly flaunt it. Conversely, an incorrect forecast negatively impacts their perceived value. On the other hand, our hedge fund manager holds no interest in "being right" for the sake of validation. His primary focus is on "making money." Consequently, he evaluates the forecasting process with objectivity and without pride, acknowledging the realities of the situation. This mindset cultivates greater flexibility, open-mindedness, and enables him to adapt his positions to capitalize on actual market conditions.

What has all this got to do with the current US macro environment? Well, possibly quite a lot. Back in February 2021, core US CPI stood at just 1.4 percent, with core PCE at 1.6 percent. Longer-term inflation expectations stood at around 2 percent. US 10-year government bond yields started 2021 at just under 1 percent. Very few people expected to see the type of acceleration that subsequently developed. And yet inflation subsequently ripped higher. 

Are we in a near mirror-image of that situation today? As more and more observers become attached to the “higher for longer” narrative and believe that the strength of the labour market will enable inflation to become embedded for a prolonged period, I think it is worth questioning whether inflation may be about to collapse in a way that surprises most market participants. 

And is it absurd to consider deflation in this environment? It’s not my central scenario but I do assign it a reasonable probability. A checklist of factors explains why.

A reversal in fiscal impulse

According to the Hutchins Center on Fiscal and Monetary Policy, an arm of the Brookings Institution, the cumulative fiscal stimulus that hit the US economy in the first quarter of 2021 was a staggering 5.3 percent of GDP. As this first chart shows, the scale of this fiscal boost is unprecedented in recent history.

The Hutchins Center estimates that the fiscal policy impact throughout 2023 will be contractionary to the tune of -0.5 percent of GDP. It’s not necessarily the size of this fiscal contraction that is relevant, but its timing. Fiscal policy is contractionary at a time when the FOMC has been aggressively raising interest rates. ‍

A reversal in global supply pressures

While fiscal policy was boosting GDP in 2021, a Covid-induced squeeze on supply channels was occurring. According to the Federal Reserve Bank of New York, global supply chain pressures rose dramatically throughout 2021, having been already very elevated throughout 2020. 

As the New York Fed’s Global Supply Chain Pressure Index shows in the next chart, supply constraints stood over 4 standard deviations above historical norms by the end of 2021. 

But the current situation is the opposite. Global supply pressures have eased significantly, now sitting at 1.3 standard deviations of “looseness.” There have only been two months in 25 years of data from this index where supply-chain pressures were so low.

In retrospect, an inflation accident should have been obvious to everyone given the extraordinary shocks of 2021.

The current situation is not a mirror-image of 2021, but it’s close.

One of the best charts to illustrate the dual impacts of fiscal contraction and easing supply chains comes from the San Francisco Fed, which splits inflation into cyclical (i.e. more demand-side) and non-cyclical (i.e. more supply-side) components. 

It’s not perfect, but it certainly captures the narrative well. When inflation really started to pick up in 2021, both cyclical and non-cyclical components were accelerating strongly. 

There has been a clear deceleration in the non-cyclical component – from a peak of 5.4 percent at the end of 2021 to 2.8 percent today. Cyclical inflation, on the other hand, remains highly elevated at 7.8 percent, close to its peak. 

Recession probability

Will weakening demand pressures see this cyclical inflation pressure decline? Hardly a day passes without an analyst somewhere pointing out that an inverted yield curve leads to a recession. 

Since 1990, there have been four defined US recessions. On each of these occasions, the US yield curve inversion provided a timely heads-up. In the next chart, the New York Fed provides a neat exposition of the yield curve and the implied probability of recession based on the degree of inversion. 

The current situation implies the highest probability of recession of any cycle over the past 30 years. It seems a good bet to anticipate recession as a central scenario. Adding support to this argument is the marked tightening in bank lending standards, which is commensurate with previous recessions.

It is logical for an inverted yield curve to imply a negative impact on GDP growth. With respect to an actual recession, I am not in the camp that believes that just because it has happened before, it must happen again. However, I do like to think in terms of probabilities.

The scale of the inversion and its demonstrable impact on credit, deposits and lending standards tells me one thing: the probability of a significant weakening in demand has risen sharply. And that’s likely to have a downward impact on the cyclical component of inflation. ‍

Monetary overkill

I appreciate that I adopt a lot of the analysis provided by the various regional Federal Reserve banks. I will conclude with a final chart from the New York Fed. 

This gauge aims to capture very broad underlying pressures and the “persistent part of the common component of monthly inflation.”  

Having peaked at 6.26 percent in June 2022, the UIG stood at 3.9 percent in April 2023. In ten months, underlying inflation has dropped by 2.31 percentage points. Over the same time period, the FOMC raised rates by 425 basis points. 

Yes, over a period when underlying inflation was declining quite aggressively, the FOMC ratcheted up the tightening. 

Given that monetary policy acts with a long lag, it is typically the case that if the central bank is still raising rates by the time underlying inflation has peaked: this represents monetary overkill. Monetary overkill lends itself to a deflation scenario.

So is it possible that a confluence of events leads to a very dramatic decline in inflation over the coming year? It is a very high probability event that inflation decelerates quite sharply. 

But could it be so sharp as to lead to deflation? My central forecast would have such a scenario as low probability. But it’s not zero – maybe 15 percent. Where would 5-year bond yields be if that was the case?

A 15 percent chance of deflation may be just enough to keep my mind flexible enough to make money – should events unfold that way.