Markets are closely monitoring what happens to inflation in the US as the world’s largest economy recovers from the pandemic-related shock, assisted by a concerted effort on the part of the Federal Reserve to push inflation higher. The extent to which this effort succeeds will set the tone for US bond yields, which then drives trends in other major bond markets.
The near-term outlook for inflation: A recovery-led increase
Consensus expectations are that US inflation will rise over the next few months as a result of base effects, that is, the unwinding of the slump in prices as the lockdowns kicked in a year ago. This will be amplified by bottlenecks that are emerging as the economy picks up steam, for example, in the labour market, but also in supply chains for commodities or semiconductors.
Ultimately, inflation is expected to ease again, according to the consensus forecast.
Obviously, there are base effects and energy prices have been rising as demand increases in sync with the economic recovery. That has been the primary driver in inflation. Prices of lockdown-sensitive services should continue to rebound as businesses open up (see Exhibit 1).
Shortages of semiconductors will ultimately feed through into meaningfully higher prices for goods such as cars and, washing machines. Meanwhile, labour market shortages might lead employers to offer bonuses or higher wages to tempt reluctant qualified workers back into jobs.
The result of those price pressures could be a rise in US inflation to a level as high as 3.8% this summer before it falls back to 2-2.5%.
Looking beyond the next few months: Further pressures
Further out, there are other cyclical factors at play. The global economy is reopening and some countries are further ahead than others are. China’s recovery from the pandemic-induced economic slump and its return to full capacity some months ago has been driving demand for commodities. As growth elsewhere speeds up, inventories will be drawn down. Restocking will sustain the upward pressure on input prices and leading companies to pass on those higher costs to consumers.
Given the generous (US) government support for household income, companies will likely feel that they do have some pricing power and can drive up consumer goods prices. Demand for labour will also underpin incomes, which will feed through into house and rental prices. In short, we are likely to see cyclical pressure on inflation.
The Biden administration’s trillion-dollar spending plans combined with loose monetary policy from the Fed look set to close the output gap rapidly, resulting in full employment by mid-2022 and a continued recovery in wages. In other words, costs for businesses will rise further, while there is a significant risk that the economy will overheat because of the large-scale stimulus.
How will the Fed react?
In the context of its new inflation framework, which involves a shift from proactive monetary policy to nip (potential) inflation in the bud to a reactive stance to effectively allow (actual) inflation to stabilise over time, the likely answer to the above question is: not.
US inflation is currently below the central bank’s 2% goal. Under the new approach, such an undershoot of the target creates room for a moderate overshoot ‘for some time’ to allow the balance to be redressed and for inflation to even out to a level at around 2%. The setup has left markets guessing as to what ‘for some time’ means.
This matters when it comes to markets setting interest rates further out. Inflation expectations are one factor and while they currently reflect a lack of action by the Fed until inflation is at target and has overshot for a while, there are structural factors that we believe should be taken into consideration when forming a longer-term view.
More structural drivers of inflation
Globalisation has been a deflationary force, but with protectionism on the rise, even in the post-Trump era, and more businesses diversifying, reorganising and reshoring vulnerable supply chains, that force looks set to weaken. Less globalisation, also in the form of tariffs on trade and restrictions on technology transfers and investments, curbs inflation-diminishing competition.
Changes in demographics in China and Europe are a second potential source of inflation. Population ageing is a factor in the form of the effects that has on pension and healthcare systems, but also on population growth and the working-age population in the next few decades.
Financing higher medical and retirement spending will ultimately involve more debt issuance, since there is no political appetite for tax increases or austerity. At the end of the day, central banks will buy more debt, and as we know, debt monetisation is inflationary.
The demographic changes could also end the global savings glut, which would drive up inflation-adjusted yields since there would be more competition for loanable funds. That might affect the sustainability of high debt burdens and create further stresses when it comes to spending on areas such as climate change mitigation that also require an answer urgently.
Again, central banks might have to step into the fray and buy more debt, effectively printing money.
Combined, all those structural factors could change inflation psychology over time.
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. This document does not constitute investment advice.
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