The inflation rollercoaster
Could we be on the verge of an inflation revival?
The inflation rollercoaster
Could we be on the verge of an inflation revival?
Professional investors only
1 Inflation forecasts are very dispersed
Uncertainty about where inflation is heading has rarely been higher
Uncertainty rules
The on-going pandemic and associated physical and economic lockdowns have created widespread uncertainty over the likely path of inflation globally. Over many years, we became accustomed to the US Fed undershooting its 2% inflation target, and investors managed their portfolios accordingly.
For this, the “higher inflation” side of the argument is gaining traction. Are investors ready for this?
According to the global macroeconomic survey firm Consensus Economics, the US CPI projection for 2021 currently stands at 2.25%. Last summer the forecast for 2021 was only at 1.7%. US 10-year inflation breakevens tell a similar story. They narrowed sharply in March 2020, from 1.60% to 0.70%, before widening consistently to reach 2.25% in March 2021 (Bloomberg).
Unsurprisingly, there is even more uncertainty beyond 2022. The latest Bank of England forecasts for UK inflation show potential outcomes for 2025 that stretch from -1% to +5%.
UK CPI inflation projection, % increase in prices on a year earlier
Source: Bank of England Monetary Policy Report, February 2021.
Covid-19 and economic lockdowns have changed consumer behaviour and prices
In the event of an exit from lockdown, we may see a rebound in activity and prices, especially in the hospitality and transport sectors
The output gap - a simple concept, but difficult to measure
The broad effects of the 2020 economic lockdowns were a collapse in consumer demand, followed by a decline in measured inflation rates. The collapse in demand left a surplus of supply in many sectors of the economy, putting downward pressure on prices. An output gap was opened.
The challenge for economists is to assess how wide that gap has become, and hence to estimate how quickly it can be filled as economies recover. When the output gap closes, the pressure on prices should swing from downwards to upwards.
2 Lockdowns have distorted supply and demand
There have been winners and losers in the price game. Predicting the net effect on CPI is tricky
What’s in store for the gym industry?
"How about a foreign holiday..."
Will the post-lockdown demand for gym membership be the same as pre-lockdown? Or will some gym members have permanently shifted to home workouts and ritzy peloton bikes?
Demand for memberships may have declined.
However, some gyms will have gone out of business during the lockdown. The supply of memberships will also have declined. Both effects will have an impact on prices, but guessing which effect will be stronger is tricky.
Another example is the pricing of aircraft ticket prices
A reduction in the number of available seats (to ensure social distancing) may lead to a need for airlines to raise prices in order to compensate for having fewer seats available. However, the demand for flying may fall if the airport experience of the future involves medical checks and a restricted list of destinations. The early evidence is that in the US the price of airline seats is currently around 30% below 2019 prices. Will airlines have the pricing power to raise them?
A sustained decline in the demand for air travel would eventually be reflected in a revised CPI basket.
Once again, it is difficult to predict the net effect on the CPI of such changes.
3 Inflation is a global story
Long-term influences include globalisation, wage inflation, and ageing
Wage inflation is key to longer-term inflation
Changes in gym membership fees, and the prices of holidays will impact the short-term trend for consumer prices.
But we also need to pay attention to the structural stories that will have a longer-term impact on inflation.
Authors Goodhart and Pradham, in their recent book (The great demographic reversal, 2021) on the subject, describe the growth of the global workforce in the 30 years from 1990 to 2020 as the “single largest labour market supply boost in history”. It began with the emergence and availability of the Eastern European workforce in the 1990s and gained considerable momentum when China joined the World Trade Organisation in 2001. And, as this global workforce grew, liberalisation of trade allowed manufacturing companies to shift production to these lower-wage geographies. Wage pricing power went in the same direction, and Chinese workers started to have an important influence on global wage developments.
The authors describe a dampening influence on global wages that lasted for three decades, moderating both consumer price inflation and interest rates. In 2000 wages in China were at a 1:35 ratio relative to the US.
Little surprise that production was outsourced from the US to China. Over time, China has transitioned into a middle-income nation, and the wage ratio is now considerably narrower at 1:5.
By 2050, one in six people in the world will be over age 65, according to 2019 data from World Population Prospects. This up from one in 11 in 2019.
The number of people aged 80 years or over is projected to triple, from 143 million in 2019 to 426 million in 2050.
Not only has the demographic sweet spot passed, but the effect will go into reverse as working-age populations start to shrink. The Chinese working-age population has already peaked and will shrink at an even faster rate than in western nations, partly due to the lagged effect of the one child policy of the late 20th century.
Do not ignore demographics
We have passed through a global demographic sweet spot
Goodhart and Pradham, 2021
There is compelling research suggesting that a positive demographic pulse had a moderating influence on inflation rates in the period from 1990 to 2020.
Demographics don’t usually play a role in investors’ considerations of where the inflation rate might go, because financial market forecasts are usually limited to a two year rather than two decade horizon.
Fluctuations in the price of oil, food (and trampolines and gym memberships) will have a more immediate impact on the numbers. However, the experience of forecasters during the 1990-2020 period would argue that ignoring long term structural forces would be a mistake.
4 The anti-globalisation force
The pandemic has arguably amplified nationalist and anti-globalisation voices
Globalisation is in retreat
The global political climate has become more confrontational
Most economists would agree that a decline in global trade, and a drive to produce more goods domestically, will usually lead to higher prices
Even before the pandemic hit, there was increasing pressure for countries to bring the production of key goods to the home nation.
The pandemic has accentuated this, as controversy over the provision of PPE clothing illustrated in 2020, and squabbling over vaccine distribution in 2021 has emphasised.
Countries where vaccines are being produced are explicitly taking care of themselves first. This can only feed the voice of populism. Geopolitical considerations have also shaped national responses to COVID-19. Russia and China are treating the pandemic as a means to extend their influence.
