Five Inflation Drivers Keeping Pressures Elevated

The Federal Reserve has embarked on a mission to combat inflation and undoubtedly possesses the tools necessary to succeed. However, the intensity with which those tools are deployed and the economy's reaction remain uncertain, as does the geopolitical landscape.

Currently, markets are discounting the smallest rate increase in American history, reflecting a broad belief that inflation will be subdued without much trouble. It is worth examining how much more effort is required on inflation and what its underlying causes are. Below are five factors I am considering:

1) The war in Iran

It is no surprise that this factor leads the list. Oil prices rose in 11 out of 12 days from the beginning of the month, followed by a small decline. The conflict appears to have reached a stalemate, with global supply constrained below global demand. The United States is accompanying tankers through the Strait of Hormuz, but this cannot be a permanent measure.

"At some point you have to decide what is the end game," Trum said. "I have a big decision coming up. Do I want to go in and annihilate them [the Iranian regime] or do I not? It's a big decision. Anything could happen with me."

That is well put. Meanwhile, supply-demand imbalances may intensify pressure and extend the time needed for crude prices to fall after the conflict concludes. For example, the US is already arranged to refill the Strategic Petroleum Reserve starting late this year. This will add incremental demand while other nations rebuild their reserves. Thus, the war's end is just the first step, with $100 oil for two years appearing quite persistent and feeding into inflation. I believe we will remain stuck at elevated oil prices for an extended period, which poses a problematic inflation signal for consumers and businesses.

2) AI expenditure and utilization

It is impossible today to discuss anything without mentioning artificial intelligence. I am convinced that over the long term, AI will be highly deflationary by replacing workers and boosting productivity. However, that long term may be many years away, as technological history demonstrates that adoption is a gradual process. Predictions that radiologists would be replaced within three years have not materialized, and the number of travel agents today equals that at the dawn of the internet.

What is clear is that AI spending is enormous, ranking among the largest in history, comparable to major wars. This is definitely inflationary, and effects have already been observed in memory chips and power generation. How to model this spending is less clear. In typical booms, a large portion of capital circulates broadly within the domestic economy. Here, much of it flows overseas and concentrates among chipmakers. Hence, while there are some spillover effects, they might prove less inflationary than anticipated.

3) The consumer sector

The spending power of US consumers should never be underestimated. Yesterday's August retail sales report was very strong, and despite all the discussion about a K-shaped economy, spending remains robust across the board. With unemployment at just 4.1% and steady, I do not expect this to change soon. A more difficult variable to model is how aggressively Baby Boomers will spend during retirement. I see upside risks there as they draw on housing wealth and accumulated stock market gains. Obviously, this does not apply to everyone, but my expectation is that consumers will remain surprisingly resilient for years, and raising rates on consumers who have paid off their homes will not have the same impact as before.

4) Immigration dynamics

ICE deportation operations may have dropped from the headlines, but they continue, and businesses in trades such as home construction are feeling the impact. Restaurants, home improvement, and hospitality will also face significant pressures from the shortage of undocumented immigrant workers. The net effect is very challenging to quantify but is undoubtedly inflationary. My guess is that this will become visible only after rates decline, but it will reinforce that the floor for the federal funds rate is 3%, not the pre-pandemic range of 0% to 1%.

5) Government expenditure

Midterm elections are approaching, and it appears the Republicans will lose the House. This would lead to a divided Congress likely to persist for some time, a situation where Republicans typically begin to feign concern about the deficit again. US spending remains far too high at 6% of GDP, but the direction of the next marginal dollar is what matters. I anticipate some pressure in the coming years to achieve a degree of fiscal responsibility, or at least avoid worsening the deficit. On balance, this should act as a drag on inflation, though one can insert their own political views here, and I would not argue with anyone who expects spending to increase further.

Baseline outlook

My baseline scenario sees the Fed continuing to raise rates, with a risk that oil keeps climbing and the fed funds rate needs to reach 5%, especially at the peak of AI capital expenditure. On the flip side, a reckoning – or at least a severe correction – in AI and technology is inevitable. When that occurs, the Fed will step in to rescue by cutting rates. Hopefully, by then the Iran war will have ended and oil prices will be falling simultaneously. That combination should generate a highly tradeable rally in rate-sensitive assets.

As ever, the challenge lies in timing.