Concerns about inflation are growing amid fears central banks may be forced to raise interest rates if pent-up demand is met by supply-side constraints.
Is the world edging towards an inflation regime change? This is the preeminent question facing policy-makers and investors as the Covid-19 recovery gets underway.
The unprecedented use of fiscal and monetary policy by most major economies, in response to the health crisis, is fuelling global growth prospects and sending jitters through fixed income markets. On the horizon, investors fear a situation in which turbocharged economies — fuelled by government support — overheat, as pent-up consumer demand and vast household savings brush up against supply-side constraints later in the year. If this happens, it could spell the end of a nearly four-decade old environment of low inflation and force the hand of central banks to raise interest rates.
Concerns over this changing inflation picture are growing. Former US treasury secretary Lawrence Summers, while speaking to Bloomberg in February, noted: “There’s a real possibility that within the year we will be dealing with the most serious, incipient inflation problem that we have faced in the last 40 years.” Meanwhile, the Bank of England’s chief economist, Andy Haldane, noted that central bank complacency was in danger of letting the “inflation tiger” out of the bag, indicating that interest rates may have to rise sooner than expected to counter the threat.
Concentrated risk
The risks, however, are not evenly distributed. In the euro area, there appears to be less opportunity for a sustained and cyclical shift in the near future, even if the bloc is set to experience an uptick in inflation figures over 2021. The factors driving these pressures are mostly transitory, including higher input prices stemming from increased shipping costs, along with expected price hikes in the services sector. Nevertheless, research from ING points to headline inflation pushing above 2% by the end of the year, representing a marked change for the region’s economy.
“What we are seeing is that 1.1% core inflation in February 2021 is a lot higher than the 0.3% recorded in December, so the underlying move upwards still stands. That means that there is basically a very simple expectation for the coming year, which is that both core and headline inflation are going to be on the rise,” says Bert Colijn, senior eurozone economist at ING.
There is a very simple expectation for the coming year, which is that both core and headline inflation are going to be on the rise
But labour market slack and subdued wage growth, coupled with a slow vaccination rollout, are likely to keep inflation figures in check. “For more substantial cyclical inflation to occur, it’s important to consider the health of the labour market and increases to wage growth,” says Mr Colijn. “These factors are correlated with a cyclical rise in inflation beyond just a temporary increase. We would have to see a very strong reopening of the economy, with unemployment remaining low and bankruptcies that have remained low not surging off the back of government support being retracted.”
Indeed, conditions in the euro area — which are mirrored in some other markets — have led to criticisms of the idea that inflation is making a comeback. For many observers, there is some way to go before it can be deemed a real concern.
“There is just nothing in the macro fundamentals over an 18-month timeline that will lead to a sustained rise in inflation. Look at the fundamentals: inflation has nowhere to come from. Labour markets are not tight and it doesn’t look like they’re getting tighter,” says Tamara Basic Vasiljev, senior economist at Oxford Economics.
Risks do remain, however, and the early warning lights in other parts of the global economy are starting to flash. “There are [still] a number of risks in terms of higher inflation being expected. [These concerns] are not completely unwarranted. Food prices are higher than average; you have oil prices climbing, as well as other commodities. You have several emerging markets experiencing severe currency depreciation, and there’s always a risk of them entering a spiral of depreciation and inflation,” says Ms Basic Vasiljev.
Governments weigh in
Other voices in the market are more confident that a tipping point has been reached. In a research note published by Bank of America (BofA) Securities in March 2021, Michael Hartnett and Shirley Wu state: “We believe 2020 likely marked a secular low point for inflation and interest rates due to a reversal of deflationary secular factors, fiscal excess and an explosive cyclical reopening of the global economy creating excess demand for goods, services and labour.”
Events unfolding in the US add weight to this perspective. The passage of president Joe Biden’s $1.9tn stimulus package, off the back of earlier support measures, has catapulted the US’s fiscal response to the crisis to north of 27% of gross domestic product (GDP). From the perspective of US households in particular, government support has been generous. Figures from Morgan Stanley point to $490bn in lost income during the pandemic, against $1.3tn in government transfers. Meanwhile, the prospect of a multi-trillion-dollar infrastructure package is also in the pipeline.
Bert Colijn, ING
These fiscal efforts go hand in hand with the ultra-loose monetary policy of the Federal Reserve, which is skewing inflation risks to the upside. It has added three dovish policy elements to its inflation-targeting regime: flexible average inflation targeting with an open-ended approach to overshooting its 2% target; prioritising employment outcomes for disadvantaged workers; and, finally, a reactive rather than forecast-based approach to its inflation goals.
“The Fed has embraced maximum stimulus relative to other central banks. It has explicitly targeted an overshoot of its inflation target. It wants to not only lower the unemployment rate back to full employment, but it wants to push beyond full employment so that the unemployment rate for marginal workers can be lowered. [These] are the two [main] components to the strategy. It’s aggressive,” says Ethan Harris, global economist at BofA Securities.
The drive to tackle unemployment among disadvantaged workers, though laudable, is new territory for a central bank. And though the existing inflationary environment can accommodate this approach, it cannot last forever. Problems could emerge when the Fed is forced to change tack and elevate unemployment in response to rising inflationary pressure.
“The Fed can temporarily create an unusually low unemployment rate for disadvantaged workers, if it is starting from a point of very low inflation and low inflation expectations. But you can’t do that indefinitely — it has to end at some point. My concern is that everything seems to be designed for what’s going to happen in the next three years without any kind of caveats in the way this is being presented. And you’re creating expectations for the Fed that are not achievable in the long run,” says Mr Harris.
Building demand
The fiscal and monetary response adopted by the US authorities has fed into a vast money pot of household savings, equating to about $2.1tn, according to research from Morgan Stanley. Inevitably, lockdowns and social distancing restrictions have generated high levels of consumer demand in the economy. “There’s a huge amount of pent-up spending power that really wants to be spent as the vaccine rollout reopens the economy,” says Jeff Rosenkranz, fixed income portfolio manager at Shelton Capital Management.
As Mr Rosenkranz notes, this mix is likely to come up against supply side constraints that could add fuel to the inflationary fire. “There are still a lot of supply chain issues, transportation issues and shipping problems. In addition, getting enough qualified workers back to work and trained, or retrained, is going to take time. So as this big wave of demand comes, you are also going to have some supply-side challenges as well. And that could really create a squeeze and push prices higher.”
Data from US purchasing manager surveys in February supports this view. Prices in manufacturing and services both reached their highest levels since 2009. The Purchasing Managers’ Index itself came in at 60.8%, up from 41.7% in April 2020. These developments, and the pressure on prices they could invite, have not gone unnoticed by financial markets. In particular, the US government debt market has endured significant turbulence since the start of the year. By March 12, these difficulties reached a high point as yields on the benchmark 10-year note hit 1.63%, up from 1.53% the previous day.
“The bond market is waking up to just how strong the economy is going to be and that there are legitimate inflation risks,” says Mr Harris.
Bond yields in the euro area have also tracked higher, as they have been dragged along by developments across the Atlantic. In response, the European Central Bank (ECB) announced plans to pick up the pace of its bond purchases through its Pandemic Emergency Purchase Programme. Speaking on March 11, ECB president Christine Lagarde noted that higher yields were tightening financing conditions across all sectors of the economy. In contrast, in early March Fed chair Jay Powell suggested the central bank was unlikely to take action to cap bond yields in the near future.
There’s a huge amount of pent-up spending power that really wants to be spent as the vaccine rollout reopens the economy
Moving forward, the Fed could face several difficulties. For one, it is anticipating full-year GDP growth of 6.5%, slightly below the expectations of many Wall Street banks. BofA Securities, for instance, is expecting an economic expansion to the tune of 7.2%. “If the optimists, including ourselves, are right, then bond yields have to go higher and the Fed is going to have a hard time managing it. They’re going to have a very confusing message: ‘We’re raising our [growth] forecast, but we don’t want bond yields to go higher.’ The only tool they have to contain it is to use bond purchases. So, it will be a fight,” says Mr Harris.
As a result, it seems likely that trading conditions will remain choppy, with further volatility expected in the coming weeks and months. “We’ve had some periods of rate volatility in the past but it’s very different when rates go from 3% to 3.75%, versus going from 50 basis points to 1.4%. Yes, they’re similar in the overall basis point increase, but the fixed-income math is very different, as are its implications. There’s just not a lot of collective experience on the buy-side or even from sell-side strategists in these conditions, so that could exacerbate volatility,” says Mr Rosenkranz.
Developments in the US bond market are already delivering a ripple effect across the wider global economy. By mid-March 2021, capital outflows from emerging markets were nearly as high as they had been during the so-called taper tantrum of 2013, according to research from the Institute of International Finance. If conditions persist or worsen, the financing environment of several emerging markets could deteriorate quickly over the coming year.
While the inflation outlook, globally, seems to be peppered with above-average risks, the distortions of a pandemic-wracked economy make predictions more uncertain than usual. A look back at the recent past, at a time when the US deployed coordinated and substantial fiscal and monetary stimulus, is therefore instructive. Between 1960 and 1965, average inflation in the US was just 1.3%, according to research from BofA Securities. By February 1970, inflation had reached 6.4%. The decade that followed was one of spiking inflation and stratospheric, by contemporary standards, interest rates.
“In the 1960s and 1970s, inflation acceleration came from both monetary and fiscal policy. On the fiscal side there was a political decision to run big budget deficits, and on the monetary policy side there was an unwillingness to take away supportive measures, knowing it would be very unpopular,” says Mr Harris.
“For a long time, the experience of the 1970s probably made the Fed too cautious. But that memory is now fading. The experience of low inflation over the past few decades is now the dominant driver of thinking. I just think that the Fed, by setting up [its new inflation targeting] goals, is creating a bias towards not only overshooting their target, but potentially overshooting it more than they would like,” he says.
