Beware fairy tales about inflation


US Inflation updates

Financial markets believe in Goldilocks. Having become more concerned about inflationary pressures over the first five months of the year, their current consensus is that price rises in the US and other advanced economies will be neither too hot nor too cold in the years ahead.

The gap in yields between nominal US government bonds and inflation-protected bonds has settled at a little over 2 per cent for the next 10 years. As Goldilocks would say, that is “just right”, allowing a high-pressure economy to maintain robust jobs growth and a gradual normalisation of monetary policy.

But reality is messier than fairy tales. In the second quarter, prices rose at rates not seen in decades. In the US, the annualised rate of core inflation rose to 8.1 per cent, its highest level in any quarter since 1982. Across the OECD advanced countries, the inflation rate in the quarter rose to a level not seen since 1995 and even in inflation-obsessed Germany, annualised inflation increased at its fastest pace since the early 1990s post-unification boom.

Line chart of US 10-year breakeven inflation rate (%) showing US financial markets have become much more relaxed about inflation since May

Central bankers insist that there is little to worry about. Higher inflation is “transitory”, they say, adding that monetary stimulus is still required to enable a strong recovery from the coronavirus crisis. They see the risks of tightening policy too early, leaving economies too cold, as worse than those of leaving things a bit late.

For Japan and the eurozone, their assessment appears well-founded, since both economies have been plagued over the past decade by persistently low inflation.

More widely, the consensus among policymakers is also grounded on some firm evidence of temporary problems in the global economy. A significant part of the recent jump in prices has come from bottlenecks in global supply chains, especially in semiconductors. Raising the price of imported goods and domestic manufactured products, this surge in costs will bring new investment in manufacturing plants and, eventually, its own cure. Increased spread of the Delta variant of Covid-19 is already moderating the recovery in household spending.

Line chart of Consumer price index (excluding food and energy), change, QoQ annualised (%) showing Core inflation in the second quarter rose to levels in advanced countries not seen for decades

But the wider case that inflation is under control is not built on similarly firm foundations in the US and UK and it is important to understand the assumptions, often implicit, that underpin the view that inflation will become much better behaved in the quarters ahead.

It is well known that both countries pursued aggressive fiscal policies after the pandemic started, seeking to compensate companies and people for their inability to work as normal. The IMF expects a US fiscal deficit of 13.3 per cent of gross domestic product in 2021, with the UK not far behind on 11.7 per cent, both considerably more generous than the eurozone at 7.9 per cent. Combined with Covid-19 restrictions, these high levels of fiscal support have resulted in higher levels of “excess savings” than in most European countries, according to the IMF.

There is nothing inherently dangerous about excess savings, especially since consumers in the US and UK are usually criticised for being too quick to spend. But it does mean that there is quite a risk of a surge in private spending coming with a decline in the prevalence of the virus. Reassuring forecasts depend on officials being correct that the fiscal authorities have calibrated support almost perfectly. As the IMF says about its own predictions: “The forecast assumes a smooth handoff from extraordinary policy support to private-activity-led growth, with a gradual drawdown of excess savings.”

The fund said that more money had accumulated in countries with traditionally low savings rates, so households there demonstrated they were likely to be rebuilding their finances. But the opposite deduction — that UK and US households with cash to spare traditionally spend it — is more plausible.

Labour markets are a second area of inflationary concern on both sides of the Atlantic. Changing its guidance last week, the Bank of England said that some “modest” rises in interest rates would be needed over the next three years, because it was no longer concerned about a rise in unemployment as much as ensuring a smooth flow of people into jobs. In the US, the labour market data similarly show job vacancies and quits at record levels, suggesting it is extremely tight despite high levels of unemployment.

Neither in the US nor in the UK is underlying wage growth yet suggesting high inflation will be persistent, but if employers continue to require more staff and the assumed surge of people back into the labour market does not materialise, continued wage and price increases will be the result.

These considerable risks in the balance between demand and supply come at a time when the ageing workforce in China suggests it will not be the force for global deflation it once was, and the retirement of the large baby-boomer generation will gradually shift the balance further towards consumption in advanced economies.

None of this suggests we are heading towards the wage and price spirals of the 1970s, but it does point towards a future in which we need to worry more about inflation than in recent years.

Mistakes are likely to happen and should be expected. The fact that financial markets expect the authorities to judge things perfectly is, itself, a reason for concern.


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