Updated: Mar 28, 2021
This is the first of a two part analysis of where inflation might be heading.
Confusion about where inflation is heading has rarely been more widespread. This has prompted a deluge of blogs and press articles, and a new record in Google searches on the topic. The rush of interest isn’t surprising. Over many years we had got used to the Fed undershooting its 2% inflation target, and investors had become accustomed to managing portfolios accordingly. Now, the “higher inflation” side of the argument is gaining traction and we are faced with the prospect of a new paradigm, perhaps even one in which the Fed’s new higher 2.25% to 2.5% inflation target is actually exceeded. Are investors ready for this?
Market expectations are clear cut
According to Consensus Economics, the CPI projection for 2021 now stands at 2.25%. As recently as last summer the forecast for 2021 was only at 1.7%. Market measures of inflation expectations, as represented by US 10-year inflation breakevens, tell a similar story. They narrowed sharply in March 2020, from 1.60% to 0.70%, before widening consistently in subsequent months and have now reached 2.25%. Unsurprisingly, there is even more uncertainty beyond 2022. The inflation fan charts produced by the Bank of England show that the latest range of potential outcomes for 2025 stretch from -1% to +5%.
Chart 1: 10-year inflation breakevens reach levels not seen since 2013
10-year US inflation breakevens
Source: Tabula and Bloomberg, March 2021
A surge in investor interest
Chart 2: Interest in inflation reaches an “internet-age” high
Source: Tabula and Google, 11 March 2021. Chart shows Google trends data for US-based Google users searching “inflation”. Numbers represent search interest relative to the highest point on the chart. A value of 100 is peak popularity. A value of 50 means that the term is half as popular.
Confusion about where inflation is heading is partly a consequence of unprecedented price volatility in many goods and services. The prices of puppies and trampolines are widely reported to have shot up, but the price of an airfare has slumped. Economy-wide measures of inflation have to calibrate the combined effect of all positive and negative price changes, and at the same time revise the weights applied to goods and services to reflect our changing spending patterns. All things considered, it is a complex situation.
Chart 3: CPI inflation projection, % increase in prices on a year earlier
Source: Bank of England Monetary Policy Report, February 2021. The fan chart depicts the probability of various outcomes for CPI inflation in the future. If economic circumstances identical to today’s were to prevail on 100 occasions, the MPC’s best collective judgement is that inflation in any particular quarter would lie within the darkest central band on only 30 of those occasions. The fan chart is constructed so that outturns of inflation are also expected to lie within each pair of the lighter yellow areas on 30 occasions. In any particular quarter of the forecast period, inflation is therefore expected to lie somewhere within the fans on 90 out of 100 occasions. And on the remaining 10 out of 100 occasions inflation can fall anywhere outside the yellow area of the fan chart. Over the forecast period, this has been depicted by the light grey background.
The bounce back in inflation rates has caused consternation. The key question for investors is whether the bounce stops here or continues and takes us to 3%, 4%, or even higher. We have not seen numbers like these for decades – and the impact on investors who have not hedged would be enormous. (The third possibility, another move lower, does not currently have many subscribers).
We see four key reasons why the bounce in inflation could continue to accelerate during 2021 and into 2022.
Firstly, the size of the monetary and fiscal response to Covid-19 related economic lockdowns has been massive, prolonged and shows no sign of coming to an end. Indeed, some commentators have suggested that President Biden’s fiscal proposals, passed in early March (he is keen to make his mark as an incoming President), could be too much of a good thing. In February, the package was expected to total $1.0 trillion. The package that was passed in early March amounted to $1.9 trillion. This is a significant change.
Recent commentary from Larry Summers has helped to frame the debate. An economic advisor to President Obama, Summers helped launch a post-GFC stimulus bill in 2009 that was only one third of the size of the Biden package. Summers has highlighted that the Biden package could trigger a wage-price spiral that would be tricky to halt. In response, the current Secretary of State Janet Yellen has made it clear that, although higher inflation is a risk, the “most important risk” would be to fail to address the economic impact of the pandemic on workers.
Implementing economic policy involves making choices about which battle to fight. US policy makers have been clear that their preference is to prioritise the creation of jobs and to accept (and deal with them later) the risks of a spike in the inflation rate.
Secondly the “inflation bounce camp” have also highlighted that they expect to see a trend for global supply chains to be reversed. Bringing production back to a home nation would likely mean higher costs in terms of labour and materials, and potentially the need to maintain permanently higher inventory levels. The “just-in-time” model will be gone, and so will its low-cost benefits. In a re-shoring scenario, the management threat to shift jobs to lower cost foreign nations will lose credibility, and bargaining power will swing back towards workers and away from employers for the first time since the 1980s.
Thirdly, there has been a surge in the supply of money in the economy. As the textbook tells us, “too much money chasing too few goods” will result in higher inflation. Although we heard something similar in 2009, it is now argued that the impact of quantitative easing in 2009 was largely contained within the banking system. Some of the recently announced measures such as financial safety nets for corporates and workers will boost the wider measures of money supply.
Finally, there was the historically significant shift in the position of the US Federal Reserve in August last year. The Fed announced that they would tolerate inflation above their previous target of 2%, to balance some of the previous undershoot of that target. This new flexibility worries some economists. If the genie escapes from the bottle, how will the Fed get it back in? Managing inflation is not like controlling the speed of a car. Momentum, once gained, might prove irresistible and lead to a significant overshoot that won’t be easy to rein in.
The output gap - a simple concept, but difficult to measure
The immediate 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 will swing from downwards to upwards. This is a logical framework for the analysis of inflation pressures, but it is a fiendishly difficult thing to measure - especially on an economy-wide basis.
Let’s take the example of the gym industry. 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 apps? If the demand for gym use is going to be lower in 2022 than 2019, this might be an argument for downward pressure on gym membership prices. However, what about supply? It is likely that some gyms will have gone bust during lockdown, so there simply won’t be as many gym memberships available. And the demand for city centre gyms will be affected by whether commuting ever returns to pre-pandemic levels, as well as overall population trends. The output gap for the gym industry will be driven by supply and demand factors that are both difficult to measure.
Another example is the pricing of aircraft seats. A reduction in the number of available seats (to ensure social distancing) may lead to a need for higher prices in order to compensate for having fewer seats available for sale. However, the demand for flying could fall sharply if the airport experience turns into a five-hour ordeal involving medical checks at each end. The early evidence from the airline industry service ARC is that in the US the price of airline seats is currently around 30% below 2019 prices.
However, a decline in demand for air travel would in turn be reflected in a revised CPI basket. In other words, the inflation impact of higher prices would eventually be offset by a lower weight in a revised basket. However, basket weight revisions are currently only carried out annually. Once again, it is difficult to predict the net effect of such changes.
The gym and aircraft examples highlight the complexities of individual sectors. Calculating the economy-wide output gap will require accurate supply and demand input from hundreds of goods and services. We may be able to explain what the output gap is in theory, but, in practice, measuring it accurately is difficult. Absolute Strategy Research have projected that the US economy output gap is currently around $1 trillion in size. If they are correct, a $1.9 trillion fiscal package from President Biden will be more than enough to fill that gap and therefore could lead to inflationary consequences that give the markets a genuine scare. An overshoot of the 2.0% target to 2.5% might be manageable (and even desirable under the new Fed regime), but what happens if the overshoot is to 4.5% instead?
Part 2 will follow next week.