Pulling apart inflation in pursuit of a soft landing

Key Points: 

• Remain slightly underweight growth assets. Markets fully understand that rising interest rates and inflation create a backdrop for recession. Indeed, in our recent TAA/DAA update we showed how our suite of indicators suggests recession is likely, but it was a little early to make this call. Consequently, we recommended investors move slightly underweight Growth assets and over the past month this tact has worked reasonably well. One reason not to go harder on the underweight is the risk that central banks can pull off a soft landing. In this note, we disentangle the US and Australian inflation data to investigate this risk.
• Supply constraints are having a large impact on inflation. A San Francisco Fed analysis of US inflation data shows that 51% of PCE inflation was driven by supply-side constraints over the past 12 months.The Fed’s immediate goal has been to restore credibility in infla- tion fighting and the plan has been to aggressively normalise policy. However, the late start by the Fed reinforces our view that a US recession is likely. Equities may continue to claw back some gains over the short-term, with the upcoming Q2 US reporting season crucial for market direction over the next month or so.
• Australian supply-driven inflation is even more significant. A key piece of analysis in this paper is done by applying the same methodology used by the San Francisco Fed to Australian inflation data. We calculate that 56% of Australian inflation has been driven by supply constraints over the past 4 quarters. Less demand-driven inflation in Australia com- bined with the relatively early withdrawal of stimulus means Australia has a better chance of avoiding recession than the US. Over the long-term 41% of Australian inflation is driven by supply-side constraints vs only 18% in the US. Australia’s oligopolistic industry structure probably explains most of this large discrepancy.
• The US has probably the most pressing inflation problem amongst the major central banks, mainly because the Fed was late to recognise the threat. It took the Fed 11 months after inflation reached 5% to start tightening policy. By comparison, the RBA had already raised the target cash rate by 75bp before inflation met this threshold.
• The most recent US manufacturing and shipping data show a mixed supply side pic- ture and It’s too early to tell whether supply chain pressures are easing. Manufacturing indicators are generally more favourable than broader measures of supply chain tightness such as the New York Fed’s supply Chain Pressure Index and the number of empty container numbers at the Port of Long Beach.