Inflation stalks the US and parts of Europe
Euro-area inflation hit 5% in December, led by Belgium and Germany. US inflation is at 7%. Meanwhile, on the other side of the world, Chinese inflation subsided to just 1.5% in December, whilst Japanese inflation leapt from negative territory to hit just 0.8%.
Chart 1: Inflation components in major economies
It is true that energy prices carry much of the blame. US energy costs soared by 29.3% over the last year, with gasoline prices up by 49%. European energy costs were up 26%. The European inflation rate excluding energy is 2.8%, still above target but much more modest than with the energy component. Japan and China too have to buy plenty of energy, so their different experience reminds us that energy prices alone are not a sufficient explanation of changes in price indices overall.
In response, the European Central Bank (ECB) has announced the end of this quarter of its special bond-buying programme to deal with the pandemic, and a tapered programme for the rest of the year from its general scheme. The Fed has said it is ending its quantitative-easing programme altogether this quarter and is likely to be raising interest rates this year.
The cycle turns
Inflation is the result of too much money chasing too few goods. It can be brought down by cutting the amount of money people and companies have to spend, abating demand and their ability to pay up to secure supplies. It can be brought down by expanding the capacity to supply the goods and services which are in strongest demand to limit the price pressures.
It is all too common for the central banks to move late.
Central banks tend to work on an explanation of inflation based around the theory that when an economy reaches full capacity it becomes inflationary, requiring the central bank to take action to limit credit by putting up interest rates in order to throttle back demand. Some combination of raising rates and cutting the amount of financial assets the central bank owns in support of markets is a blunt instrument which will bear down on demand. It is all too common for the central banks to move late when the inflation is already well set, and to then overdo the remedy creating a recession.
Chart 2: CPI, money-supply growth, and long-term rates in the US and the Eurozone
Central banks no longer adhere to monetary theory, which states that if they create or allow the creation of too much money through market interventions and interest rates then they will generate inflation.
The Bundesbank prior to Germany joining the euro used to target money growth as its means of control. It did this well but lost this control on transition to the euro. Over the pandemic period, the Federal Reserve and the ECB have allowed abnormal growth of money. In the first stages of lockdown this was a necessary offset to the collapse of demand and activity brought on by physical controls. Monetarists say they continued with too much money creation for too long, facilitating higher inflation.
There are those who attribute the current inflation to a supply-side crunch. We can all see the damage to supply chains brought on by lockdowns. The energy shortage was exacerbated by days of little wind energy in systems where wind is now a more important part of the mix, and by Russia and Opec rationing the output of gas and oil to drive up prices or to get diplomatic leverage.
Another buoyant area, particularly in US inflation, has been car prices. A shortage of chips and a reluctance or inability to buy new cars has driven second-hand car prices higher and has allowed price rises for new vehicles. The industry is also under regulatory pressure to sell more electric vehicles which are more expensive. On both sides of the Atlantic, excess credit and money has found its way into property markets. In the US, housing costs have risen substantially.
Chart 3: Inflation drivers in the US and the Eurozone
So, what happens next?
In the short term, there will be further energy and supply shortage pressures before we pass the peak. If the central banks are right, inflation will subside from current high levels in the second half of the year when comparisons from 2021 are higher, lowering the stated rate of climb. They will be wrong if wages take off.
Central banks need employees to settle for below-inflation rises on the grounds that current inflation rates are a temporary spike. Were employees generally to press successfully for pay rises that gave them a real increase, that would mean wage rises of 6-9%. This would then trigger more price rises as employers sought to recoup the extra costs. That is why the main central banks and investors are watching wage trends very carefully.
In the US, the labour market is tight, as many people seem to have taken early retirement or are pausing their availability for full-time jobs, leading to some wage pressures. Europe has more unemployment.
Our base case assumes a tailing off in inflation later this year, based on the supposition that average wages growth will be below peak inflation levels. The absence of inflation in Japan despite zero interest rates and substantial bond buying by the central bank reflects a declining and ageing population with restrained purchasing habits. It continues to reflate and still find it difficult to hit the 2% target. China has been slowing its economy for some time and deliberately trying to take speculative excess out of its large and bloated property sector, so her lower level of inflation is no surprise.
Meanwhile, central banks on both sides of the Atlantic will tighten more and worry markets. There is a more serious inflation problem in the US than in Europe, where there are more Japanese-style characteristics. The European Union has an energy problem more than an inflation problem, as the numbers show.
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