Quick Take: Los Angeles Fires Highlight Upside Inflation Risks

Summary

• Ongoing Los Angeles (LA) fires are causing large-scale destruction of housing, infrastructure and production assets, with uncertain and costly reconstruction.
• The fires highlight the impact of climate change as a negative supply shock and cast doubts on the Fed’s hopes that above target services inflation can be offset with below target goods inflation.

Market Implications

• I expect the Fed to remain on hold in 2025, against markets pricing about two cuts.

Costs and Regulations to Limit Post-Fire Reconstruction

LA fires remain uncontained and could turn out the most costly in the world with preliminary damages estimates above $50bn.

Fires happen regularly in California and have worsened in recent years. As in Florida, that is exposed to another type of natural disaster, hurricanes, private insurers have jacked up rates and started to withdraw coverage of areas most at risk. This has led both states governments to set up a state sponsored insurer of last resort.

It is likely California’s state sponsored insurer, FAIR, will be unable to absorb the cost of the ongoing fires. Under current laws, some of FAIR losses could be passed on to private insurers but the scale of the damages suggests additional state resources will be needed. Otherwise, private insurers could leave California altogether!

The shoring up of FAIR with state money could prove politically contentious as taxpayer money would in effect be used to indemnify the owners of some of the most expensive real estate in LA. consequently, California will likely reconsider its insurance plans and zoning laws.

Longer term, government and private insurers are likely to create new restrictions on construction and safety requirements. For instance, prior to the current fires, State Farm had already announced it was withdrawing cover to 69% of its policies in Pacific Palisades, one of the areas hit by the fires. A full rebuilding with the same density of the LA communities that have been hit may be unfeasible because some of the properties are in areas at high fire risk.

Fires Show Inflationary Impact of Climate Change

From a macro perspective, the fires illustrate how climate change is a negative supply shock. Besides the direct destruction of housing, production assets and infrastructure, extreme weather is lowering the productivity of existing assets. For instance, regular droughts reduce canals’ usability (e.g., Panama Canal) and lower the associated revenue stream.

Also, business operations become more expensive as additional protection and mitigation of climate hazards must be implemented.

That is one reason I am skeptical the pre-pandemic US goods deflation has returned permanently. Data is pointing in the opposite direction (Chart 1).

The Fed hopes that, like pre-pandemic, below target goods inflation can offset above target services inflation. LA’s tragic events suggest this may be unfeasible.

Market Consequences

I still expect no Fed cuts in 2025, against market consensus for two cuts.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)