Stagflation still a more likely near term scenario

US market participants seems to be desperately looking for an end point where the Fed will finish with its monetary policy tightening as hopes are that the growing likelihood of a recession and recent drops in commodity prices will cool inflationary pressures. Thus, bets that the US central bank will cut rates as soon as early next year are rising while a stagflation scenario will be avoided. 

We are not so confident of such an outcome as we see inflationary forces, particularly within the service sector, rents and wages becoming increasingly entrenched into the economy as we have been highlighting since summer of last year. Indeed, since the war in Europe in February, we had come to the view that stagflation is a more likely economic scenario for the second half of this year. 

Although easing of commodity prices have indeed cooled inflationary expectations while improving conditions in component shortages and logistics bottlenecks will all help ease pricing pressures in some segments of the economy, it is difficult to see how inflation target of 2% can be achieved for the foreseeable future. Unless, central banks become more tolerant of higher inflation rates, we can’t see how easier monetary policy from early next year is a realistic scenario.

Moreover, with crop yields likely to start deteriorating from here as fertiliser shortages stemming from the Ukraine war will likely to begin hurting productivity of food producing nations and great deal of agricultural land in Ukraine having been lost by Russia’s attacks, we think higher food prices could prove far more sticky. Also, even though oil price has eased thanks mainly to financial markets betting on end-demand cooling, much still depends on Russian gas supplies to Europe to avoid an energy crunch this coming winter. 

Moving quickly on to our own market in Japan, we think PM Kishida’s latest directive to restart number of nuclear power plants by the end of the year is a good plan. We think the restarts could greatly help ease the power crunch Japan is facing today and should help reduce its dependence on imported energy.

Nevertheless, we continue to think that BOJ’s continued intervention in the JGB market to keep long term rates artificially low is a huge policy error that will weigh on the Japanese currency to depreciate further, raising import costs and widening Japan’s trade deficit in the near term. This will in turn add more downward pressure on the yen which has created a negative feedback loop which is unlikely to broken until BOJ capitulates and allow longer term rates to be determined by market forces. 

With ECB most likely to start tightening its monetary policy from this week, we think BOJ will be increasingly isolated and its continued easy policy stance will come under more scrutiny, especially if we prove correct and inflation in Japan continues trend higher. Anecdotally, we thought the news that the retail giant Uniqlo is raising wages of its Japanese part-time staff by as much as 30% was a rude reminder that with structural labour shortages persisting, rising prices in Japan will likely go far beyond just food and energy sectors.