Author: Melanie Baker
Melanie Baker, Senior Economist at Royal London Asset Management, is relatively sanguine about the risk of high sustained inflation, though she takes note that stronger than expected recovery and inflation expectations are risk factors
Inflation has become a big talking point among investors. For most countries, headline inflation has risen, and the question of whether higher inflation is “transitory” or not is frequently being asked. While it is not a surprise that inflation has spiked, the magnitude, in some cases, has surprised. For example, US consumer price inflation has risen particularly sharply.
It’s transitory: Energy prices play a key role in higher year-on-year inflation, having fallen to very low levels last Spring and risen again since. Some sectors hit hard in the pandemic have also pushed through price increases on reopening, though these are likely to be one-off adjustments in price levels rather than ongoing sources of inflation. Supply chain pressures and patches of labour shortages are also adding to inflationary pressure; while demand is rising as economies reopen, supply is being held back temporarily. Mooted reasons have ranged from Covid-19 having affected capacity at ports, to delayed full school reopening in the US holding back the labour market supply. Adjusting to life after Covid-19 is likely to continue to mean supply disruptions for a while, but not permanently, and the demand boom of reopening economies will fade.
Three reasons inflation won’t stay at high levels: There should be an increase in underlying inflation pressure as slack in economies is eliminated in the recovery. However, this is more likely to stop inflation falling back below central bank targets than keep inflation at elevated levels. Even in the case of a stronger than expected recovery, I find it hard to see high inflation being sustained:
- The factors that were bearing down on consumer price inflation before the pandemic will still be there afterwards. These include: the growth of internet retail (this may have been accelerated by the pandemic); global competitive pressures; and the lack of worker bargaining power and unionisation. These factors may lessen, but that’s not really a story for the next two years.
- More generally, the US and UK were both able to run their pre-crisis economies with very low levels of unemployment, but still maintain unexciting inflation rates. Why will things be any different this time around when the dust settles on this crisis and fiscal support eases (as it is set to globally over the coming year or so)?
- Probably the main reason I am relatively sanguine about the risk of high sustained inflation is that I don’t think central banks have changed. Many of those who are very bullish on inflation medium-term think that this time is different institutionally. However, inflation targeting is still at the heart of central bank mandates – sustained high inflation should see central banks tighten.
However, a bigger, more persistent upside inflation surprise is a significant risk if the recovery is much stronger than expected. Vaccine rollouts are progressing, fiscal support for economies over the crisis has been huge, monetary policy remains very accommodative and there is fuel for a strong consumer expansion using savings built over the crisis in developed economies. In a very strong recovery, supply chain pressures may become even more apparent and last longer.
Inflation expectations are important. If inflation expectations rise significantly, then what were temporary shocks to inflation can become more permanent. US inflation expectations have picked up and the Federal Reserve has moved towards an inflation averaging framework, indicating that it will tolerate a period of above target inflation. However, US inflation expectations have mostly picked up to levels seen six year ago or so. The Federal Reserve will likely see that kind of level as consistent with meeting their inflation target. Additionally, policymaker tolerance will have limits. Federal Reserve chair Jerome Hayden Powell has repeatedly said that if inflations expectations move persistently in a way that is inconsistent with their goals then they “wouldn't hesitate to use our tools to address that.”
Some have been looking to history for guidance when pointing to the risk of more persistently high inflation outcomes. However, there are flaws with this approach. Firstly, if you go back before the early 1990s, the institutional framework is too different. That is, we now have inflation targeting and independent central banks across the developed world. Secondly, there hasn’t ever been an episode quite like this. The last comparable global pandemic was the Spanish flu in 1919, but that followed a devastating world war and occurred against a very different institutional backdrop. At any rate, analysis suggests that pandemics don’t tend to be inflationary – they tend, if anything, to have been deflationary according to work done by the San Francisco Federal Reserve.
You can go back to previous episodes of very high inflation and ask whether there are any similarities in economic backdrop that could lead us down that path, e.g. the high inflation period of the 1970s. But, again, we have a very different institutional backdrop now. We have largely independent inflation targeting central banks (even if coordination with fiscal policy and changes to central bank mandates have somewhat tested this over the crisis) and the likes of the US and UK are not heavily trade unionised in the way they were in the 1970s - the link between inflation and pay growth is weaker now.
Implications for asset markets: Whichever side of the inflation debate you are on; it makes sense to re-evaluate protection against a higher inflation backdrop. My central case is that we are on a path now to see higher policy interest rates, but I don’t think that economic fundamentals have changed so much that we are going to see a break towards the kind of inflation rates we saw before the mid-1990s, or even the kind of policy rates we saw pre-financial crisis. I would expect that 10-year government bond yields are likely to settle at higher rates over the next couple of years, but not substantially higher. Assets that tend to outperform in a higher inflation, rising interest rate environment include commercial property and commodities.
Melanie Baker is a Senior Economist at Royal London Asset Management