This is Linchpin’s thirteenth annual update, in which we monitor a range of inflation indicators. The aim is to provide investors with a framework for assessing long-term inflation. Last year, we suggested that, while central banks had regained some measure of control, the longer-term indicators looked ominous. The past 12 months have not prompted a change in our view.
LINCHPIN INFLATION INDICATORS
The dial has moved further towards inflation
Last year we said that the dial had moved a little towards inflation. That move has continued this year, with six (five in 2024) of our 12 indicators now pointing to Inflation, four (five) to Neutral, and two (two) to Deflation. The pressure is coming from the Market and Policy Action (i.e., actions by central banks and governments) indicators, where in total three have moved to inflation. Against that there is downward pressure from the supply indicators, principally weak growth in both the West and China, and the higher cost of leverage.
Central bank policy succeeded in bringing inflation down to 2% or thereabouts following the COVID years. However, the last few months have seen some unwelcome upticks, and the latest consumer inflation datapoints in the U.S., Japan, the U.K. and the Netherlands (as examples) are all above 2.5%. China, which we highlighted as an outlier last year, remains so with the headline CPI figure at -0.2%.
Monetary debasement has pointed to inflation throughout the thirteen years we have monitored these indicators and is now the driver behind our long-term inflation expectations. The U.S. government is running a primary deficit of 7% a year, which the Federal Reserve is finding increasingly difficult to finance in the traditional way through coupon-bearing bonds. It is therefore turning to short-term bills which do not bear coupons but are issued at a discount.
Their intention is to suppress yields by reducing bond supply in order to avoid the cost of debt service rising. The clearest evidence for this is the 60bps gap between the 10-year U.S. bond yields and an agency mortgage bond of similar tenor. Prior to 2023 the gap was zero; since then it has tracked between 60bps and 150bps.
As we commented last year, this is effectively renewed QE. Instead of issuing bonds and buying them back with short-term paper, the Federal Reserve is simply issuing short-term paper. In practice we are off to the ‘magic money-tree’ again, which is why monetary debasement remains the greatest long-term threat to investors.
Market indicators are inflationary
Our market side indicators have moved towards inflation. Bond yields are back at their previous post-COVID highs in the U.S. and have breached 5% (at the 20-year maturity) in the U.K. There remains a significant gap between the U.S. break-even inflation rate (i.e., the difference between conventional and index-linked gilt yields) at 2.0% and the U.K. at 3.4% at the 10-year tenor. While these numbers are little changed from last year, we have moved this indicator from neutral to inflationary because as above we believe the U.S rate is about 60bps under-estimated.
The gold price moved to new highs of US$2,700 during 2024, up about 35% from the previous year’s high point. This is being driven by Chinese state buying, perhaps as a hedge against a future yuan deflation. Gold’s role as the ultimate store of value may have been partially taken over by digital equivalents outside the central banks’ control, such as cryptocurrencies, but it is still signalling a higher risk of monetary debasement.
Supply-side indicators have moved the other way
Supply-side pressures continue to move away from inflation. The two main drivers are i) falling producer prices in China and ii) lower energy prices. Chinese producer prices have consistently been deflationary for the past two years and in November 2024 were 2.5% lower than a year earlier. There has been a continuing build-up in inventories as demand for Chinese goods is impacted by lower global growth and increasing trade friction. We have moved the overcapacity indicator from inflationary to neutral for this reason.
The price of energy has fallen considerably with the notable exception of natural gas. This may reflect the increasing supply of renewable energy and some success by Russia in evading sanctions. Other commodities reflect a mixed picture. Iron ore prices have fallen in 2024, but copper has held up, perhaps a reflection of the growing use of electricity. Wheat fell 15%, but coffee and other food commodities rose. Among precious metals, often seen as a bottleneck for many high-end consumer products such as mobile phones, the price of lithium fell, but gallium rose 23%. We have marked the commodity prices indicator as neutral.
Governments will drive new spending
Demand indicators remain mixed. Private demand (in the west) is suffering from higher borrowing costs and higher taxation. Perhaps the largest shift in the past twelve months has been the willingness of governments to embrace fiscal expansion. In some cases, this is military necessity as the world becomes more confrontational; in others it is a sign of political weakness in the face of increasing health and other demands; and the U.K.’s new government is embracing a path of higher public investment.
In theory government spending is self-limiting as the cost of borrowing (i.e., bond yields) becomes prohibitive. However, governments can avoid that by resorting to printing money, as the U.S. now seems to be doing. The important point here is that governments by their nature tend to be less price-conscious than private individuals or entities, and therefore government spending is more inflationary.
The Trump administration is a wild card. On the one hand we can expect tax cuts; on the other hand, there is a clear determination to cut spending, for example by reducing U.S. involvement in foreign wars. If he succeeds, we tend to think that the rest of the world is swinging to the right and will eventually follow his example.
Monetary policy is pivoting to a looser stance
Last year we thought monetary policy would start to loosen in the second half of 2023. We were not sure that this pivot was needed and worried that looser policy might add to inflationary pressures. A year later global economic growth is low and, while we can expect further limited cuts in 2025, we are less concerned about their being inflationary.
The real danger remains monetary debasement in the longer term
Over the past 12 months we have become much more concerned about the long-term. The “magic money-tree” beckons for governments with debt service costs rising sharply and little political capital to use on reining in fiscal deficits. We reflect that since the 1960s, governments have been lucky in that they have either had stronger growth (1960s), lower debt levels (1970s through the 2000s) or low interest rates (2008-2022). These have given them a ‘get out of jail free’ card on the cost of servicing their debt.
None of those seem likely to happen over the next ten years, while governments will be under pressure to spend more on defence and the health and welfare of their ageing populations. At the same time the cost of debt service is vulnerable to either higher bond yields or higher inflation. Much will depend on the success or otherwise of the Trump experiment of slashing both taxes and expenditure.
If you would like to discuss anything in this article, please contact us on research@linchpin-advisory.com.
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