Inflation: Back to the future?

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Inflation: Back to the future?
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Signs of inflation are growing more obvious, from soaring shipping costs; rising energy, food and general commodity costs; to shortages of products and labour.

The Citi Global Inflation Surprise Index, which measures actual inflation against economists’ forecasts, is at its highest since the series began in the late 1990s.

The cost-of-living crisis makes disturbing headlines, but talk of stagflation is probably too extreme. With the global vaccination programme breaking the link between Covid cases and hospitalisation, there is still potential for a rebound to more normal levels of services activities.

This could be fuelled by large amounts of excess savings of 5 to 10 per cent of GDP, accrued by households across most developed economies during the pandemic, and should sustain a decent level of global growth in 2022.

However, growth may be associated with uncomfortably high inflation and force central banks rapidly to reverse the extraordinary amount of monetary support provided during the pandemic.

This outcome is not yet priced into financial markets and could lead to a derating of asset prices, which are being propped up by today’s low, long-term interest rates.

The greatest focus is on US inflation, as the US dominates the structure of global interest rates: if the US Treasury market comes under pressure, it will drag up interest rates around the world.

Inflation is currently well above the Federal Reserve target, with core consumer price index at 4 per cent in September and expected to rise further into early next year.

The view from the Fed

For months, Fed chair Jerome Powell has been arguing that this increase is largely transitory, and that economic slack would mean inflation should quickly ebb away.

Initially, this argument was well supported by the data: price increases were narrowly focused and linked to the reopening of the economy, experiencing a ‘one-off’ recovery from their lockdown troughs.

Isolated supply-chain disruptions, such as in semiconductors, also led to some erratic price gains, most notably the 40 per cent surge in used car prices.

But the Fed narrative could be about to shift as price pressures are broadening across goods, rents, recreation services and restaurants. This has been reflected in an acceleration in the median CPI over the past couple of months, even though the monthly readings on overall core CPI appear softer than earlier in the year.

The Fed probably expects the pressure on freight rates to decrease sharply in 2022. There does not appear to be a shortage of ships, but they have ended up in the wrong place and have been unable to offload their cargo.

Goods demand has been unusually strong, as consumers shifted expenditure away from ‘close-contact services’.

Substantial, relative price shifts should encourage movement of resources to alleviate these bottlenecks, and demand should rotate back to services as reopening continues.

As the current exceptionally low level of inventories normalises, this could lead to some reversal of the price hikes we have seen in goods, pulling inflation back closer to target.

Still, supply-chain disruptions could linger well into 2022 and pricing intentions are very strong, suggesting that higher costs could be passed onto consumers.

But the big puzzle is the degree of labour-market slack. Despite US employment still around 5m jobs below the pre-pandemic level, unemployment has fallen sharply and there are widespread reports of labour shortages.

This is not unique to the US; the Bank of England is equally confused around the role of furlough in creating surprisingly strong wage pressure, but in the case of the UK, the impact of Brexit on reducing immigration is an additional factor.

There has been a hesitancy of people to return to work. This has been attributed to early retirement, worries around Covid, caring responsibilities and generous income support from the government.

The question is the extent to which participation rises now that unemployment benefits have expired and as Covid fears subside.

The Fed’s new framework (known as flexible, average inflation targeting) was deliberately designed to box itself in, given the previous persistent undershoot of inflation and uncomfortably low inflation expectation.

It never expected inflation to overshoot before maximum employment was reached. Now it has committed to no longer act pre-emptively, so it lacks the flexibility to respond to the current inflation shock without potentially disrupting markets.

Furthermore, this new approach risks dislodging previously well-anchored inflation expectations and setting off a wage-price spiral.

Lessons from the past

Despite worries around inflation, a return to the 1970s seems unlikely. Central banks appear more independent and have learned from the mistake of allowing inflation expectations to ratchet higher.

Should more persistent inflation pressure begin to emerge it seems likely that central banks will perform a policy pivot to prevent a serious outbreak. This could involve a more abrupt taper or sudden stop in asset purchases, followed by rate hikes.

But to draw this conclusion will likely take more time to assess how labour markets respond to economies attempting to fully reopen as government support is withdrawn.

However, a sudden move higher in longer-term inflation expectations could trigger an even more urgent response and would be potentially highly disruptive for markets.

Tim Drayson is head of economics at LGIM