investment insights
Post-reopening inflation: a persistent risk?
How rapidly the economic and market narratives have shifted. Earlier this year, uncertainty was rife, with concerns in particular as to the damages inflicted by the Covid shock in terms of jobs and corporate defaults. Today, the recovery is seen as secured by available (at least in the West) and efficient (even against the known variants) vaccines, residual excess private savings and still substantial – both monetary and fiscal – policy support.
In fact, the strength of the unfolding recovery is leading to an intense debate about the risk of “overheating”. Inflation, both expected and actual, is rising sharply. Which bodes the important question: are these price pressures only transitory or will central banks be forced to adjust their reaction function?
We are not overly worried about persistent inflation, for three key reasons. First, after a downtrend as large and sudden as that caused by the pandemic, a normalisation in prices was bound to occur.
Second, the flare is neither broad-based nor global. Inflation remains modest in China or Israel, despite their economic recovery being more mature, and still below target in Japan, Europe and Switzerland. In the US, it stems predominantly from components such as airline fares, hotel rates and used car prices – sectors that are very sensitive to the reopening of the economy or are suffering supply shortages. By their very nature, these types of price increases are unlikely to be sustained. As demand patterns normalise and supply bottlenecks are addressed, prices should stabilise – and some of the recent large jumps reverse.
Delving further into the bottleneck issue, with the recovery now extending to the euro area (following in the US footsteps), it is very clear that western supply is having trouble responding to demand. This is partly a consequence of companies having relied extensively on inventories during the Covid shock. The necessary stock rebuild will take some time and lead to a surplus of activity in the coming quarters. But such domestic supply tensions should wane later in the year. Further, there is some available capacity elsewhere in the world, Asia especially, to fill the gap. Chinese authorities have provided only marginal support to household income, making for persistently weak domestic consumption and thus leaving some spare capacity to respond to foreign demand. Indeed, to offset its self-imposed frugality on the policy front, Beijing needs foreign demand. Chinese producers do also face constraints, as well as cost pressures (especially on commodities such as copper, steel, cobalt and lithium), but delivery time surveys suggest that these are much less acute than in the West.
Finally, on the labour market front, despite the benefits of reopening, the recovery process is unlikely to be linear, and arguably vindicates the Federal Reserve’s (Fed) commitment to remain patient and keep policy accommodative until substantial progress in the real economy becomes visible. Slack in the US job market may be diminishing fast but, still, it remains significant. The spread between black and white unemployment is also proof that the economy is not yet where the Fed wants it to be. Until this excessive slack is eliminated, organic wages (i.e. stripping out the non-recurring impact of government stimulus checks) will remain subdued. And it is difficult to imagine persistent inflation without substantial and sustained income growth.
Given the Fed’s new average inflation targeting regime, that tolerates a period of inflation before a shift into tightening gear, we thus expect the following policy sequence going forward: a tapering announcement sometime between August 2021 (Jackson Hole Economic Symposium) and the end of the year, to be implemented throughout 2022 at a USD 10 bn monthly pace (there is a USD 120 bn monthly purchase program to unwind, which mechanically will take time), and then a first policy rate hike by mid-2023. In our view, current market expectations of a hike already in 2022 are extremely conservative.
That said, and despite what we believe to be a strong base case scenario, it is always important to reflect on how the situation may come to evolve differently – towards sustained high inflation. While base price effects and supply chain disruptions are, by definition, not lasting, generalised worker shortages in the context of a rapidly tightening labour market, combined with excess demand backed by strong monetary and fiscal stimulus, could have an altogether different effect. If companies, encouraged by the strong growth backdrop, pass on their higher wage costs to consumers, a wage-price spiral could be set into motion. In turn, this could lead to rising inflation expectations across the economy – potentially boosted by the Fed’s commitment to allow inflation to “overshoot” for some time. And while central banks have in the past proved able to bring inflation under control by tightening policy, this is not always a smooth ride – likely to prove even harder if inflation expectations get de-anchored.
For now, however, continued progress on both the vaccination and reopening fronts confirms our outlook for strong 2021-2022 growth in most major economies, with inflation normalising but not shifting to a permanently higher regime. The persistence of policy support secures the recovery and should prevent a major relapse – absent of course an unexpected external shock.
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