Not the 1970s but not the 2010s either

Inflation concerns have been rising up the market agenda during the course of this year. These fears appeared justified following last week’s release of US CPI inflation data which showed a jump from 2.6% in March to 4.2% in April – the highest rate since September 2008. This week’s UK release also showed a big jump in CPI inflation from 0.7% in March to 1.5% in April, and whilst the pickup in euro zone inflation was more modest (to 1.6% from 1.3% in March) it is now at its highest in two years. Obviously there are base year effects at work with last year’s total shutdown in activity making price measurement in April 2020 extremely difficult. Nonetheless, there are indications that price pressures are building. How worried should we be?

Dissecting CPI inflation data reveals the extent to which it has recently been driven by the recovery in oil prices. Recall that in April 2020 the price of Brent dropped to a monthly average of $18 versus $64 in January and $56 in February and whilst it subsequently recovered, it was only in February/March 2021 that oil got back to pre-pandemic levels. But whilst US core CPI inflation stood at only 3% in April – more than a percentage point below the headline rate – it was still almost double that in March and its highest in 25 years. On the basis of price trends further down the chain, consumer prices are likely to rise further. Aside from oil, industrial metals such as copper have reached record highs whilst there have been well-publicised warnings that shortages in key industrial components such as semiconductors will also push up prices. A further warning sign is that Chinese producer prices are now running at their fastest pace since late-2017 (6.8%) suggesting that price pressures in the workshop of the world need to be viewed with caution.

In addition to the base year effects, the inflation pickup in 2021 reflects the concerns expressed a year ago that the damage to the supply side of the economy during the lockdown would generate a pickup in inflation as capacity bottlenecks emerged. If this is the case, then surely the recent resurgence in inflation will prove temporary. This is not to say we will not see a further big rise to levels which many people might think scarily high, but it does suggest that we are not on the verge of a 1970s rebound. To the extent that inflation is driven by the difference between what economies consume and what they can produce (the output gap), and given that output gaps across the OECD remain in negative territory, suggesting that there is plenty of capacity to accommodate any pickup in demand (the average across the OECD is estimated at -5.2% in 2021 - see chart below), there is no obvious sign that a sustainable burst of inflation is in the offing.

It is true that lax monetary policy has helped support the rebound, leading in effect to a monetary-induced burst in inflation, but the expectation is that this will be temporary. As the demand catch-up from 2020 begins to fade, so it is widely expected that demand-supply pressures will ease and price inflation will slow (hopefully back towards central bank targets). The likes of the BoE have adjusted to this by slowing the pace of asset purchases although it has not adjusted the overall target for the stock of asset purchases which is ultimately what matters for the degree of monetary easing. 

Although it is expected that inflation in the UK and US will overshoot the central bank’s central 2% target we should view this in part as a consequence of the post-pandemic adjustment process. Indeed, there is likely to be a change in the product supply-demand mix which will leave an overabundance of productive capital tied up in areas where demand has declined, whereas there is a shortfall in areas where demand has increased. Accordingly we might expect strong inflation in some classes of goods and services, whereas in others it is weaker, which might persist for some time until the demand-supply balance has been restored.

Central bankers will thus be closely watching inflation expectations for some time to come for indications that it is set to take off. But inflation expectations differ according to who we ask. For example, the BoE’s survey of UK households shows that they have consistently overestimated expected inflation over the past 20 years. There is thus a strong argument for attaching a low weight to household expectations. In any case, households have limited bargaining power when it comes to setting wages so their weight in the price setting process is limited. Moreover, financial literacy amongst many households is not as high as it could be with the result that the concept of inflation is often hazily defined. Much of the academic literature thus attaches greater weight to the expectations of companies and those priced into financial markets. From a financial market perspective there has been a small pickup in inflation expectations, as derived from 5y5y swaps in the US and euro zone (chart below), but it is no higher than at any time in the last five years. Nor does corporate survey evidence across the industrialised world suggest that a pickup in wage inflation is likely anytime soon.

For all these reasons, some of the more lurid headlines suggesting that we may be on the brink of a 1970s-style inflation pickup are likely to be wide of the mark. There appears to be plenty of spare productive capacity; inflation expectations remain well anchored (for the moment); the ability of organised labour to push for higher wage claims is much more limited than it was 50 years ago plus – and this is perhaps the critical difference – in an increasingly global economy, inflation is a function of world rather than local conditions. None of this is to say that inflation will not run above target. The BoE, for example, looks for a UK inflation rate above 2% until around autumn 2022 although crucially it is not expected to exceed the upper 3% band.

If, however, we are about to experience higher inflation there is also a case for taking away some of the extreme monetary easing put in place over the last year. Over the last decade, central banks have used the argument of low inflation as a reason for keeping the pedal to the metal. Above-target inflation surely warrants a move in the other direction.