Patrick 00:00

Welcome back to the Barclays Brief. It's Patrick here. So, today on the podcast we're focused on inflation. And the question is: is this 2022 all over again? In the near-term, markets are dealing with another energy shock. Oil prices are rising again and familiar worries about inflation prints, expectations and the response of central banks is at the fore. But beneath that a bigger question is emerging; and that's whether core inflation is drifting back towards its pre-COVID pattern. And whether the bigger force shaping inflation, longer term might actually be disinflationary, driven in part by AI. 

So, to discuss all of that, in the space of just ten minutes, I'm joined in the studio by Jon Hill, who's our Head of US Inflation Strategy. John, great to have you on. Thanks for being here on the Barclays Brief.

Jon 00:51

Hi, Patrick. Excited to be here. I have some good friends who have always told me I have a face made for radio, so I feel like a podcast could be a nice in between.

Patrick 00:59

They sound like great friends. Jon. Clearly the obvious question that everyone cares about, no doubt your friends as well, is: is this inflation shock likely to be as painful as 2022? So, when you look at inflation markets, things like breakevens and real yields, what are they telling us? And are markets treating this as a temporary shock or something more persistent?

Jon 01:22

So, when I look at this, I think one of the biggest things to emphasize upfront is the initial conditions for this energy price shock are dramatically different in 2026 versus 2022.

Four years ago, the Fed still had policy rates at zero when Russia invaded Ukraine, there was an active QE (quantitative easing) program, realized inflation was over 7%, there were more than two job openings for every unemployed person. This time around, policy rates are well into positive territory on the high end of neutral, we don't have a QE program, the labor market has softened dramatically, and when you put those pieces together, it makes it more likely that this won't be a sustained, persistent shock.

And frankly, the market is pricing that as such. 5-year 5-year breakeven, for example, pretty much haven't risen at all since the end of February when the war with Iran began. 

Patrick 02:09

Okay, so let's focus on the near term then. When energy prices spike like this, what are the main channels through which that feeds into inflation, you know, and is the market focused and worried about headline inflation, core inflation or simply higher uncertainty?

Jon 02:26

The main channel, and don't get me wrong, we will get higher prices in response to this - we already have. The main channel is going to be through energy commodities i.e. gasoline. And that's something the market knows how to track and knows how to price. And we get very good data on what the bigger question I guess becomes is, do you see it outside of just this mechanical pass through to higher gasoline prices?

And this is where topics such as food via fertilizer come up or even airline fares, right. Like part of your plane ticket every time is going to be the jet fuel price. And while we do expect upward pressure on there, it's still relatively contained to a certain number of months. Food inflation could persist, maybe into H2 or something, but it's not a sustained new inflation process that leads to persistent inflation into 2027 and 2028. And that's one of the differences between 2022.

Patrick 03:18

Yeah. It's interesting. We had Andrew Lobbenberg talking about jet fuel shortages on the podcast last week. And that's clearly a very big concern for consumers. I was at a children's party with my son at the weekend, and I was talking to one of the mums about food price inflation. You know, we were talking about how we go to restaurants far less than we used to. That's clearly also a big concern for consumers. But beyond those sort of short-term and dare I say obvious things, how could this become more persistent for inflationary markets? 

Jon 03:47

Yeah, that's one of the big questions, right? Is in order to have that process play out in airline fares, you basically need jet fuel prices to continue rising in perpetuity. That's a tough sell. Instead, one of the ways this becomes more ingrained and this becomes a true inflation process or wage price spiral, is if you start to see pickup and wage growth, because otherwise, if you have pretty constant wage growth and the cost of everything you're consuming goes up, that means that your wallet share for those other components goes down. 

That's a demand destruction kind of hit. So, if you're trying to be worried about this becoming more persistent, and I imagine investors and central banks globally are going through exactly this, one of the biggest channels is going to be if you start to see the show up in inflation expectations, you start to see this show up in wage pressure.

Patrick 4:35

You talk about wage pressure. Are we seeing any evidence of that yet? 

Jon 4:39 

I mean, if you look for it, you can potentially find it, but it almost feels like a Rorschach test. One of those where if you look at a whole variety of different factors, you know, there's some evidence, yes, there's some evidence, no. The job switcher category, the Atlanta Fed wage growth, for example.

But it's not broad based and persistent yet. And this is one of the key things as to whether central banks are going to be able to look through the energy price shock, or they might have to respond while implementing more restrictive monetary policy.

And on this topic, I think one of the things that's going to be really interesting with central banks is which measure of core inflation do they focus on. You know, I pay attention to markets that CPI (consumer price index). Traditionally, the Fed pays a lot of attention to core PCE (personal consumption expenditures price index) that looks very elevated. Whereas incoming Chair Warsh has indicated he might want some alternative measure like trim PCE. So even if you're trying to focus on core inflation, it partly depends on which measure you're reading.

Patrick 5:33

One of the things that central banks are grappling with at the moment is AI as well. And in your recent work, you've argued that the core inflation dynamics are drifting back towards pre-COVID configurations. So, what does that actually mean in practice, and what evidence are you leaning on for that claim?

Jon 5:50 

I mean, so this is just me trying to take a step back and think, what's going on behind the curtains. You can think of core inflation pre-COVID in the US as core goods running about flat, shelter inflation was a bit elevated and core services ex-shelter was in the middle. So, the weighted average that was 2%. 

Now what's kind of interesting is that after we get through the tariff impulse now the expectation as core goods goes to about flat, shelter might actually run quite a bit lower than pre-COVID for a while. So then just to get to 2%, you need core services ex-shelter to actually pick up. And this is where AI comes in. If there was going to be an area where you're worried about labor market disruption, where you're worried about wage suppression or layoffs or whatever it is, you know, you could see it manifest in that super core or services ex shelter. And this is where, you know, the underlying core dynamics get a little bit a little bit tricky. It's not obvious. The medium-term risk is actually massively skewed to the upside.

Patrick 6:46

Right. Yeah. So, when you layer in that idea of AI meaningfully disrupting labor markets as well, how can that translate into lower inflation over time? You know, is this mostly a wage story, a productivity story, or maybe a margin story?

Jon 7:01 

I mean, I think of it through kind of a wage story, right? Like for first principles, something like AI should be a positive productivity shock. That should be a rightward shift to the aggregate supply curve. That's more output. That's more productivity, but also lower prices because of better technology. And that's where I think in the medium-term people talk about this being disinflationary.

You don't necessarily need to assume some mass unemployment scenario to get there. You just kind of need to make the argument that, hey, we're able to do more at a lower cost, and that leads to a lower wage story. And, you know, from my perspective, it's one of the reasons why something like 5- or 5-year break evens are really struggling to move dramatically higher, even as Iran as pushing up energy prices sharply in the near term.

Patrick 7:45

Yeah, okay. And what about kind of longer term then? You know, you've said I think that markets should eventually be pricing a negative core inflation risk premium beyond the near term. It's a pretty strong claim. What does that actually mean and where do you think markets are getting it wrong today, if indeed do you think they are getting it wrong?

Jon 8:02

Well, that's one of the crazy things, is that if you look at 30-year breakevens in the US, they’re priced below target consistent levels, not massively so, but slightly so. And that, I think, runs counter to some of the narrative that huge debt levels or whatever are going to drive this big inflationary risk in the US 30-year breakevens, just aren't telling that story.

And, you know, for me, it's just one of those where you try to be a little bit nuanced about what's going on underneath the hood. It's not to say this is a one year or two-year story, but it's kind of when you look at the more tectonic factors that are playing out, how could this play out 5 to 10 years forward? Given what we know now, it's not obvious that we should be expecting 3% inflation in perpetuity. 

Patrick 8:48

No. Definitely not. So basically, what you're saying is the Fed has got a tough job. You know, they need to anchor short-term inflation expectations. Clearly, they can't control oil prices. But they also have an employment mandate. Putting that together with the AI narrative - the tectonic plate that you talk about, how do you think they're thinking about rates in the short term? And also, how would they think about AI in that kind of medium long term as well? 

Jon 9:12

Yeah, I think one of the things that's extremely clear in their messaging right now is they see very high uncertainty. So they think, let's wait and see. Policy rates are on the high end of neutral and given the level of geopolitical uncertainty, given that they don't necessarily know when this is going to end or how it's going to play out, it makes sense to hold off on any additional policy adjustments. But you roll the clock forward far enough, it's not crazy to therefore have a cut bias going forward, and that's actually what you see in things like the SAP dots. That's what you see in some of the communication from different fed officials. And I think the upcoming fed Chair Warsh is going to be very instrumental in this, he's talked about how AI could be a disinflationary force.

The tough thing, though, is it's hard to see evidence of this looking at the realized data. You know, one of the classic critiques of monetary policy is it's like driving a car, looking at the rear-view mirror. If you only look at realized information instead, this is where that inflation expectation becomes so, so important is it gives you a forward-looking guidepost.

And I expect it to be something where the fed is watching these survey measures, these market-based measures of inflation expectations extremely closely to see if inflation expectations are getting de-anchored and if so, in which direction. 

Patrick 10:27 

Yes. Fascinating, isn't it? So, if you pull it all together, Jon, are we moving into a world where inflation is just structurally more volatile? It's being pulled on the one hand between geopolitical supply shocks, like the energy spikes that we're seeing because of the war in Iran on the one side. And yet on the other side, you've got the disinflationary impact of AI and technology.

Put the two together. It creates far more volatility in inflation markets than we've seen before. Is that too simplistic or do you think there's some validity in that argument. Or do you think there's some validity in that argument? 

Jon 10:57 

There's absolutely some validity in that argument. And you’re seeing rates markets price that for example five-year CPI swaps, so, market pricing for inflation over the next five years much higher than 5 to 10 years out, much higher than long run inflation risk. And so, it's not unreasonable at all to think that we might see near-term upward pressure because of the war in Iran, because of the AI CapEx build out. And in the long run, as the saying goes, we're all dead. The question is, what happens in the medium run? And that's where monetary policy needs to be very careful to make sure that inflation expectations stay well anchored.  

Patrick 11:33

Great. Well, there's so much to watch for, so much look at. And I know you're going to be writing more and more about this over the course of 2026 and beyond. So, Jon, thanks for joining me on the Barclays Brief today.

Jon 11:42

Absolutely a pleasure. Thanks for having me 

Patrick 11:44

So, it's been great to be joined by Jon in the studio today. And I should say we're recording this on the 11th of May, the day before the April US CPI print. But the way I think I'd framed this conversation is the market's pendulum is swinging between inflationary energy shocks and disinflationary AI forces. So, if energy's grabbing the headlines today, AI could turn out to be the far bigger force shaping inflation concerns tomorrow. Thanks for listening. Do hit subscribe and we'll be back here next week with another episode of The Barclays Brief.