Macro Signposts | 10 December 2024

This week, I asked members of PIMCO's real return portfolio management team to guest author Macro Signposts and share their insights into global inflation trends.

Global Inflation: Is the Tide Turning?

By Steve Rodosky and Daniel He

U.S. inflation has dropped from a staggering peak of 9.1% during the height of COVID-19 to a more manageable 2.6% as of October 2024, as measured by the headline Consumer Price Index (CPI). This dramatic shift raises important questions about the trajectory of inflation: Are we on the cusp of a return to the golden era of low and stable inflation that characterized the economy from the 1990s to the mid-2010s? Or are we reverting to a historical norm marked by inflation averaging above 2% and heightened volatility?

The upshot is we believe the tide has most likely turned: Inflation may be more volatile and linger above central bank targets. Several global macroeconomic trends drive this view. And for investors, this means assessing portfolios' resilience to inflation - and to inflation surprises. Real assets, such as inflation-linked bonds, may offer attractive real yields and inflation hedging.

The golden era of low and stable inflation
The period from 1990s to mid-2010s had remarkably low headline inflation in the U.S., averaging just 2.4% (see Figure 1). This compares with an average inflation rate of 3.6% over the 75 years prior and 3.4% since 2016. More remarkably, the volatility of inflation during this period was a mere 1.2%, versus 5.6% and 2.2% in the other two periods. When viewed from the lens of a 110-year history, the era of calm appears more as an anomaly than a standard (see Figure 1, top panel).

Figure 1: 110-year history of U.S. inflation and global conflicts

Figure 1

Source: Bloomberg data, OurWorldinData.org, Uppsala Conflict Data Program, Peace Research Institute Oslo, and PIMCO calculations as of 31 October 2024

A closer examination of this unique period reveals key macro trends underpinning lower inflation.

The years leading up to 2016 were marked by a significant degree of global peace, with the lowest number of deaths in history from state-based conflicts. (see Figure 1, bottom panel). This environment coincided with a period of international cooperation and stability - including accelerated globalization. This trend started with the end of the Cold War in 1991 and signing of the Maastricht Treaty in 1992, establishing the European Union. The North American Free Trade Agreement went into effect in 1994, soon followed by the formation of the World Trade Organization (WTO) a year later. The arguable pinnacle of globalization was China's accession to the WTO in 2001, unleashing "the factory of the world."

The reduced levels of global conflict and the higher levels of trade integration may have bolstered each other in a self-stoking cycle. Overall, this extended period of relative peace and globalization supported economic growth, stabilized (or lowered) the prices of many goods, and helped tame inflation volatility.

During this time, world imports of goods and services increased from 18% of total world GDP to 30% of GDP, according to the World Bank. In fact, after China started producing for the world within the WTO, goods inflation in the U.S. went negative before hovering near zero. Because services inflation remained well above 2%, goods disinflation was the key to keeping overall U.S. inflation low throughout the period (see Figure 2).

Figure 2: Goods disinflation vs. services inflation in the U.S.

Figure 2

Source: Bloomberg data and PIMCO calculations as of 31 October 2024

The golden era ends
Just as it seemed that we had found the perfect formula for keeping global inflation low and stable, conditions began to turn. The rise of populist political movements globally, exemplified by the Brexit referendum in 2016, marked a departure from the cooperative spirit of the previous decades. The U.S.-China trade war in 2018 symbolically rang the opening bell for deglobalization. The COVID-19 pandemic and Russia-Ukraine war further disrupted global supply chains and prompted many countries to reconsider their reliance on global trade. That led to further momentum in near-shoring and friend-shoring. By 2023, Mexico overtook China as the top exporter to the U.S., according to the U.S. Census Bureau, for the first time since 2004 (shortly after China joined the WTO).

Moreover, the world is now experiencing more conflicts than at any time in the past 30 years, ending the peace dividend that had previously fostered cooperation and suppressed inflation (Figure 1, bottom panel). Just as globalization and peace tended to grow in tandem during the golden era, so might deglobalization and conflict in the years to come.

What lies ahead for inflation?
The reversal of conditions means we could stay in a higher inflation and higher volatility world. The trend of goods disinflation that characterized the previous era is likely coming to an end as deglobalization takes hold. Simultaneously, services inflation may be boosted by populist anti-immigration policies, potentially leading to less labor supply and higher prices.

In the near term - or longer, depending on future governments - fiscal policies, trade policies, and geopolitical tensions also pose significant risks to inflation. With the U.S. fiscal deficit projected to remain above 6% (according to the Congressional Budget Office), and the potential for tariffs to increase significantly across the board (as U.S. President-elect Donald Trump has indicated he intends to do), the inflation landscape is fraught with uncertainty. Additionally, geopolitical risks in Europe, the Middle East, and Asia - particularly concerning Taiwan - could disrupt supply chains and accelerate inflation.

Central banks will seek to keep inflation (and inflation expectations) near target via ordinary and perhaps extraordinary means, but these global trends could pose clear challenges.

Investment implications
The potential return of elevated inflation volatility carries several important implications.

Long-term breakeven inflation rates are currently priced at 2.3% (according to Bloomberg), exactly the same as the average inflation during the golden era (and just above the Federal Reserve's target), indicating a lack of risk premium despite recent inflation spikes, the near-term inflation risks, and a potential return to a higher inflation and higher volatility regime. As inflation surprises become more likely, the risk premium should rise.

Given the evolving inflation landscape, investors may need to reassess their strategies. Real yields on U.S. Treasury Inflation-Protected Securities (TIPS) are currently at 15-year highs (see Figure 3), exceeding the Fed's model estimates of neutral rates by 75-125 basis points (according to the New York Fed), presenting an attractive opportunity for those seeking to hedge inflation.

Figure 3: Real yield on 10-year U.S. TIPS at 15-year high

Figure 3

Source: Bloomberg data as of 29 November 2024

A multi-faceted approach to real asset hedging could significantly enhance portfolio resilience in the face of potentially rising inflation and increased volatility. Learn more in our recent article on real assets.

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