Is this the onset of the second inflation wave?

Last week’s release of fresh inflation data revealed the economy’s vulnerability towards the vagaries of inflation. While services CPI remained stubborn, oil price gains fired up headline numbers again. A second wave may be a possibility, but even more pressing is a required adjustment by investors to the reality of a non-linear and slow inflation decline coupled with slower growth that could last until 2025.

After being on a measured retreat, inflation reared its head again in August rising from 3.2% in July to 3.7% y-o-y, missing expectations by 0.1% that had anticipated 3.6%. Core inflation decreased a tad but continues to account for the bulk of inflationary tendencies. Energy still exerts disinflationary pressure but to a lessening degree as oil prices continue to advance.

So, should we be worried?

The short answer is: Kind of.

Oil has made significant headway recently due to a mismatch between rising y-o-y demand and tightening supply as the global economy still grapples with satisfying post-pandemic demand overhang and a strong consumer. Despite various economic headwinds such as interest rate rises and inflation many economies have seen robust activity fueling the demand for oil and oil products. At the same time, OPEC+ has been restricting supply by reducing output to bolster the market against possible downturns and growth rate cuts that many countries are facing over the next months as monetary policy effects continue to build up. Therefore, further upside to oil prices is possible while the downside seems protected not only by OPEC but also by the US government who intends to replenish its emergency oil reserves bit by bit targeting a price around 70 USD which essentially provides another layer of support to a possible floor price.

Therefore, oil could indeed pose a threat to the disinflationary tendencies which we have been seeing of late bearing in mind it was the energy component specifically that contributed most to disinflation over the past months.

On top of that, and perhaps more importantly, services CPI continues to prove extraordinarily sticky due to a buoyant consumer, even if it has made some retreats. Wages and shelter are the two most rigid components of services in a sense that once they dig in on an elevated level, they are less likely to budge. Price-wage spirals are particularly nefarious for economies that want to fight inflation. While labor markets have eased a little bit lately, unemployment hovers still at historical lows and central banks are far from satisfied and will want to see more pronounced signs of cooling off before they let up. As many union negotiations are still coming up in major sectors in important countries, such as the automobile sector in Germany, price-wage spirals could still develop and deepen adding to inflationary pressures in the months to come.

An equally pressing question is though where the new equilibrium interest rate will be as central banks keep extending this hiking cycle that everyone hoped would be over by now. Reaching the ambitious 2% target appears increasingly far-fetched making a revised objective of 3 to 4% more likely. Against this background, investors are adjusting their rate expectations, discarding rate cuts for next year and instead counting on them only from 2025 onwards. Not surprisingly, the European Central Bank increased rates last Thursday by another 25 bps, cut growth expectations and upped its inflation outlook for 2023/2024 while pointing towards a slowdown in growth that could last until 2025. As to the U.S. Federal Reserve, it is highly doubtful if it can really adopt a wait-and-see stance when it moves on rates this week given the latest data.

Overall, energy will remain a bit of a wild card and services are likely to embark on a meandering downhill walk rather than a linear and swift downward trend which makes upticks in inflation possible. However, spikes to high single-digit or even double-digit numbers are rather unlikely. Nevertheless, even smaller upticks could spook markets, so best to brace for the possibility of volatility sprints.