This spring inflation resurfaced to the global macroeconomic discussions with a strength not seen in many years, or even decades. Why now, and should investors brace for higher inflation?
Before the pandemic, too low inflation and even deflation fears were the main worry of the central banks. The global financial crisis, which started in 2008 and the European sovereign debt crisis which followed it, shifted central banks’ focus from inflation control to fighting against insufficient demand and deflationary forces.
All major central banks in developed countries brought their steering rates rapidly down to zero and eventually started sizeable asset purchase programs to support their ailing economies through easier financial conditions. Despite sizeable support measures by the central banks and recovering economic activity, realized inflation and inflation expectations stubbornly stayed below central banks’ inflation targets for years.
Things have now changed, however. Inflation is back. Price increases have speeded up around the world during the first half of this year. In May, the US consumer price inflation hit 5 per cent, and eurozone inflation reached 2 per cent in May for the first time in nearly 10 years. Eurozone’s inflation now exceeds ECB’s inflation target of close to, but below, 2 per cent. In UK, inflation also surprised on the upside in May and settled at 2.1 per cent.
As the economies are gradually reopening from lockdowns caused by the pandemic, world economy is experiencing one of the strongest recoveries after WWII. Buoyant household consumption growth and firms’ investment demand are lifting economies from the slump. At the same time, strong demand for commodities (oil, metals, etc.) and bottlenecks in production as well as and in recruiting are pushing up producer prices and wages.
Sure, part of the inflation spike is due to so called ‘base effects’ in certain product categories, for example energy prices fell last spring due to lockdowns. And yes, most likely bottlenecks in production and recruiting and inventory problems are pushing up prices and wages only temporarily.
The real question is what happens after the current spike in inflation? Are there forces and institutions in the economy which will keep price and wage pressures elevated after an initial inflation shock? Will workers in the next wage negotiations and in bargaining rounds demand compensation for unexpected inflation, which has eroded the purchasing power of wages and salaries? And more importantly, if the vicious cycle of price-wage increases would ignite, are the central banks ready to react accordingly?
In the US, Biden administration’s ultra-loose fiscal policy, which distributes sizeable direct income support to households, is fueling price pressures by increasing demand at the same time as the supply in product and labour markets is already struggling to keep up with the demand after lockdowns were lifted. Biden’s ‘going big’ strategy in economic policy aims at inclusive growth and prosperity. It is a daring experiment, which obviously will support working class and middle class people in the short term. However, if stimulus measures turn out to be too big relative to the slump in the economy, overheating, inflation and the needed policy reactions thereafter will hit the same groups the hardest.
The reason why the US developments are currently followed very intensively is the fact that consumer price inflation has reached 5 per cent, and the economic policy mix of fiscal and monetary policy is extremely expansionary. The Fed announced last fall a new strategy of targeting 2 per cent inflation on average, which in current circumstances means that the Fed will allow inflation to hover above 2 per cent for an undetermined period. The Fed has also communicated that in addition to sustained inflation, the full-employment level needs to be reached before policy tightening is called for. This ‘outcomes-based’ policy differs substantially from earlier and more conventional strategy, where the Fed would react to changes in inflation expectations and forecasts.
In Europe, the issue of runaway inflation is not as pressing as in the US. The ECB is still actually fighting against deflationary forces and too low inflation expectations. However, the ECB just recently upgraded its growth projections and inflation forecasts for the current year. The economic impact of the pandemic was also much more severe in Europe than in the US, and the recovery seems to be slower. This implies that overheating worries are premature in Europe.
Labour market developments, however, should be followed very closely also in Europe. Unemployment is still high in many countries due to the pandemic, but at the same time firms are reporting recruitment problems. This suggests that mismatch problems are on the rise and will tighten the labour market and increase wage demands despite high unemployment.
So, what is the likely outcome of all this? At the end of the day, the Fed will react and raise policy rates enough to bring down inflation. Fed Chairman Powell’s comments after last week’s meeting of the rate-setting committee gave more room to inflation worries than previous communications. The Fed raised inflation forecast for the current year substantially. Also, the ‘dot-plot’, that is, the committee members’ subjective views of the most likely steering rate path in the coming years, brought the first interest rate hikes a year forward to 2023. This also implies that the Fed will start talking about ‘tapering’, that is, reducing monthly asset purchases, in the coming months. The actual tapering will most likely be postponed to year 2022.
The Fed’s new outcomes-based policy entails, however, a clear risk that the Fed will be ‘behind to curve’, that is, they will start scaling down asset purchases and raising interest rate too late. Monetary policy affects inflation with long and variable lags, as Milton Friedman put it a long time ago. A central bank which steers the economy by looking out of the window will inevitably be acting too late. And if monetary policy tightening comes too late, the needed action is larger, and a recession is the most probable outcome.
And where would this policy mistake of the Fed lead the global economy and the markets? Substantially higher rates in the US would push up interest rates in Europe as well and tighten financing conditions. Higher rates would turn capital flows towards the US and emerging market countries would be the most severely hit. And if the dollar would strengthen, highly indebted emerging market countries with dollar denominated debts would face severe economic problems.
The Fed gave last week first hints to the markets that it takes inflation risk seriously. This was a welcomed message. When central bankers are not worried about inflation, investors should be.