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How transitory is inflation?

Central banks have underestimated inflationary pressures following the easing of pandemic-related lockdown measures. What happens now?

| 6 min read

The central banks underestimated the amount of inflation their policies and the relaxation of pandemic restrictions produced. They knew there would be a temporary upturn, but not on the scale we have seen.

US inflation has reached 5.3% and German inflation 4.1%, well above official forecasts earlier this year. The Federal Reserve (Fed) in December 2020 forecast 1.8% inflation for 2021, raising this to just 2.4% in March. The Bank of England in March was forecasting a upturn in inflation to 2% in the spring but thought inflation expectations would remain well anchored and that there was plenty of spare capacity to restrain prices. Mirroring the central banks, the EU forecast 2.8% inflation this year for Germany and rates mainly under 2% for many of the other EU countries. Euro-area inflation is now running at 3.4%.

The worst inflation rates around the world are found In Venezuela, at 2000% or so – Argentina at 52% and Turkey at 19.6%. In these cases, government policy of spending and borrowing on a large scale has overwhelmed central bank action, which has in turn been politicised to allow the governments to run inflation-prone policies.

The emerging world still has more inflation than the advanced world with Brazil at 10%, Mexico at 6% and India at 4.3%. The inflationary tendencies of some emerging market countries are reinforced by depreciation of their currencies. The Brazilian real has fallen from 5.27 reals to the dollar last month to 5.66 now. The Turkish lira has fallen from 8.62 lira to the dollar last month to 9.63 now. As the currency slips away, the authorities normally need to take some action to cut budget deficits or rein in credit with rate rises.

In Turkey, Recep Tayyip Erdogan does not wish to accept the cruel logic of a sliding currency and rising prices and wants to continue to run hot and press for growth. Brazil is having to reduce some spending. Brazilian, Russian and other interest rates are now on the rise to constrain things.

China is well advanced with a policy of slowing the economy and starting to tackle some of the excessive debt overhangs, most notably in the property sector. None of this is helpful to world growth, but it does demonstrate that inflation still has the power to worry most governments and to force policy change in due course. Where a country is determined to ignore the problem, as with Venezuela, the inflation can get out of control and make normal economic activity very difficult to conduct.

Complacency in the west

In the advanced countries there was a complacency about inflation as the recovery got underway. The central banks all took the view that inflation would not rise too high – and it would quickly subside again to close to the 2% targets. They are now having to revise their forecasts, admitting the higher levels already reached. The advent of substantial energy-price inflation could continue the inflation surge into 2022, considerably longer than the original promise of transitory pressures.

There is also more evidence of wage inflation than the central banks thought likely earlier this year. With many countries ending work subsidy and furlough schemes it was assumed there would be a plentiful supply of potential labour to offset the needs of business re opening after lockdown to avoid wage inflation.

Instead, marked shortages of drivers, catering and hotel staff, care staff and other lower paid employment is producing upwards pressures in their wages. The supply shortages have also induced other price rises. The shortage of semiconductors has led to a shortage of new cars and a noticeable acceleration in the prices of second-hand vehicles. Disruption of supply chains for some foods, raw materials and finished goods has produced other price spikes. The sharp rise in timber and iron ore rapidly reversed, but other shortages are more persistent.

So, today’s big debate is how much longer will the supply shortages last? Will they spread further? Could there be a more general move-up in wages as people try to defend their living standards from price rises, and as people see the opportunity to job hop to better their rewards? The central banks with their models based on the idea of a general capacity can point to areas where demand is still below supply offering some containing pressures on prices. There are, however, a worrying number of areas of the goods, services and labour markets where people and goods are in short supply and the inflationary pressures real.

The central banks are going to have to update their forecasts and views on inflation in a credible way. They are likely to do so continuing their narrative that inflation will subside again next year, allowing for longer and higher in the meantime. They are being persuaded to do more to bring about this outcome. The UK ends its bond buying and money creation this year. The Fed will soon give more details on how it will phase out its bond purchasing.

South Korea, New Zealand, Hungary, Poland, Mexico, Brazil, Russia, Norway and Czechia have already had a rate rise to send a message about their wish to curb price rises. Others will follow. The consensus view is that they will do this moderately, slowing economies but not stopping them. This will produce a dullish outlook for shares and a bit weaker bond market whilst the adjustment occurs.

There are two bad risks out there. One is the central banks do too little and the inflation imbeds. Wages rise reinforcing the price rises. People and companies start spending some of the large pent-up liquidity assembled over the lockdown creating more inflationary demand. The other is they do too much and bring on a recession, which would be bad news for share values and in due course rally bonds as the inflation collapsed. We are watching these risks closely.

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How transitory is inflation?

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