Yes, inflation is currently a global phenomenon
Global supply factors related to supply chain disruptions and energy markets (see Exhibit 1 below) are clearly an important part of the explanation for recent rises in key measures of inflation across advanced economies. The persistence of this inflationary pressure is due to factors such as production or shipping bottlenecks and higher input prices.
These factors are mostly global in nature and as they are supply, rather than demand related, domestic monetary policy actions are likely to have only a limited effect on them. In short, the sooner there is an easing of tensions in supply chains, the faster we will see inflationary pressures fading everywhere.
Exhibit 1: Global supply chain pressures remain high, but may have begun to moderate – graph shows changes in the global supply chain index between September 1997 and December 2021
Source: Federal Reserve Bank of New York, as of 04/02/2022
Important differences between the US and eurozone
Beyond these global factors, there are fundamental differences, particularly in labour markets, that lead us to believe it is inappropriate to transpose the outlook for inflation in the US on to the eurozone (the UK’s situation being, not for the first time, somewhere between the two).
We see the US economy as being at or already below full employment. The labour market is tight with around 10.5 million open positions. Fed Chair Powell’s comments after the late January FOMC meeting suggest to us that policymakers have concluded inflation is becoming cyclical and persistent.
We therefore expect the FOMC to raise the federal funds rate by at least 0.25% at each of its seven policy-setting meetings in 2022 and continue in 2023 until US policy rates reach 2.5% (in line with the Fed’s view of ‘neutral’).
With the FOMC’s core inflation forecasts at above target throughout its forecast horizon and likely to be revised higher should wages not moderate in coming months, it is entirely possible that rates may have to go into restrictive territory.
A hawkish tone at the ECB
President Lagarde, meanwhile, adopted an unambiguously hawkish tone about upside inflation risks in the eurozone at the ECB’s press conference on 3 February. Policy action is not imminent, but the ECB clearly sees inflation risks as now being skewed to the upside. She noted that inflation concerns were ‘unanimous’ among the governing council members, as recent high headline inflation data, still driven by energy, shows broader inflationary pressures extending to core items in the basket.
An upward trend in core inflation, along with expectations of further improvements in the labour market and inflation expectations stabilising at around target, suggest the ECB now sees inflation as settling at elevated levels for some time, potentially a pre-condition for a rate rise.
Particularly noteworthy was a shift in language on rate rises as Lagarde no longer referred to an increase in 2022 as ‘highly unlikely’, but rather stressed that any decision will be data driven.
ECB to do less than the Fed
In our view, on account of a significantly larger output gap and greater slack in labour markets, the ECB is not about to embark on a cycle of rate rises of the same magnitude that we expect from the Federal Reserve.
While the European labour market is tightening, real wage gains are unlikely to outpace productivity gains by much – wage increases will be part of the price finding adjustment rather than the trigger for a wage-price spiral.
In the US, in contrast, the acute shortage of workers is far more conducive to a wage acceleration that could lead to significant pass-through and second-order effects.
Correspondingly, while the ECB may take its foot off the accelerator in coming months, we think the Fed is far more likely to be the central bank that needs to tap the brakes.
Nevertheless, with the ECB, the Fed and the Bank of England now all heading towards a wind-down of their balance sheets and higher policy rates, investors should prepare for higher real yields and a reversal of portfolio balance effects.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
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