MACRO AND MARKETS
Inflation genie drivers
26. Feb 2021
Once post-Covid economic growth accelerates, will inflation spiral out of control? flow’s Graham Buck examines current measures and past performances for indicators
Is Federal Reserve Chairman Jerome Powell a tad too relaxed about the spectre of escalating inflation once the US economy recovers from the impact of Covid-19?
His Semi-annual Monetary Policy Report to the Congress on 23 February1 suggests he’s not overly concerned. “The economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved,” said Powell. The Fed was “committed to using our full range of tools to support the economy and to help ensure that the recovery from this difficult period will be as robust as possible”.
He added that the coronavirus crisis had left a “significant imprint” on inflation. “Following large declines in the spring, consumer prices partially rebounded over the rest of last year. However, for some of the sectors that have been most adversely affected by the pandemic, prices remain particularly soft. Overall, on a 12-month basis, inflation remains below our 2% longer-run objective.”
As Deutsche Bank Research’s team of US economists, Justin Weidner, Matthew Luzzetti and Brett Ryan, note in the 17 February report US Economic Perspectives: Managing Inflation Expectations, US inflation expectations slipped just as they became more important in the inflation process. The Fed responded in August 2020 by changing its approach to monetary policy, which was outlined in its Statement on Longer-Run Policy Goals.
They explain that “the Fed no longer considers unemployment running below target a sufficient reason for raising interest rates and will take into account inflation shortfalls (or overshoots) over longer time periods when setting monetary policy, a so-called flexible average inflation targeting strategy”.
“Because of this new strategy, the Fed would be more accommodative of inflation overshooting the 2% target, at least moderately.”
“The economy is a long way from our employment and inflation goals”
Yet rising bond yields in 2021 and a sharp reversal by the stock markets on both sides of the Atlantic at the end of February suggest investors are less convinced that inflation will remain tamed. Tech stocks, which have enjoyed a strong bull run since the start of the pandemic, fell on concerns that higher inflation and bond yields could trim their future profits. And as Deutsche Bank Research’s Strategist, Jim Reid, noted in his Early Morning Reid – Macro strategy commentary of 1 March, over the previous week investors had been moving forward their expectations for Fed rate hikes “to the point where they’re now pricing in two full hikes by the end of 2023. If realised, that would represent a faster move than the Fed have implied”.
The Bank of England is also less sanguine on the inflation outlook than the Fed. “At present, temporary factors relating to Covid are weighing substantially on inflation,” notes its February 2021 Monetary Policy Report. “These are expected to unwind in the near term, leading to a sharp pick-up in inflation towards the monetary policy committee’s 2% target.”2 The Bank’s Chief Economist, Andrew Haldane warns that as economies reopened, a likely consumer spending boom promises to boost activity just as massive levels of fiscal stimulus are working through the system.
"People are right to caution about the risks of central banks acting too conservatively by tightening policy prematurely,” said Haldane in a speech released on 26 February3. “But, for me, the greater risk is of central bank complacency allowing the inflationary cat out of the bag.”
Post-Covid recovery is also expected to lift inflation in other major economies; for example in the Deutsche Bank Research white paper of 1 March 1, Focus Germany: German pent-up demand to boost growth in summer 2021, senior economist Marc Schattenberg writes that “the reopening of the stationary retail trade and the broad spectrum of service businesses should be accompanied by a strong revival of private demand. In combination with possible supply-side bottlenecks, some significant price increases are to be expected during the economic recovery.”
He adds that a similar story is likely in other Eurozone countries “especially if the economic constraints caused by Covid-19 are resolved synchronously, as vaccine deliveries or vaccination coverage is happening in lockstep in the different countries” and the European Central Bank should prepare for inflation to be fuelled by strong demand meeting tight supply.
“Combined with the current macroeconomic backdrop of ultra-expansionary monetary and fiscal policies that are likely to reverse later rather than sooner, these factors could, in the worst case, lead to structurally higher inflation dynamics.”
Subdued in the short term
Deutsche Bank Research Strategist Jim Reid has for some time warned that 2021 will be a complicated year for financial markets. In his 1 March 2021 commentary he wrote “The forces working in both directions (high growth and stimulus versus inflation and higher yields) are huge and both sides will dominate for periods causing us to move between extremes.” Reid added there is “little doubt” that US growth will be very strong – the Bank’s economists recently upgraded their Q4/Q4 2021 growth forecast to 7.5% – and added “With inflation this could mean nominal GDP getting close to 10%. The last time we were in double digits was the early 1980s.”
Reid explained that before the pandemic, he had written that inflation may be near to an inflection point mainly because he thought “we were moving more towards a helicopter money/modern monetary theory (MMT) world and away from fiscal austerity”. In flow’s May 2020 article Covid-19 and inflation, we considered whether after 30 years of low inflation this benign era could end abruptly once lockdowns are lifted and economic activity picks up. Since then, comments Reid “the pandemic has accelerated this and a Blue Wave has picked up the baton in its crest.”
Even before President Biden’s US$1.9trn American Relief Bill kicks in (if approved by the Senate), boosting an economy that is already growing at 4% based on Q4 2020 data (and with a proposed more than doubling of the US minimum hourly minimum wage from US$7.25 to US$15), 4 there are signs of inflationary forces stirring. Reporting on the January 2021 US consumer price index, which showed prices – excluding food and energy costs – just 1.4% higher year-on-year, Bloomberg headlined the piece ‘CPI data show pandemic continues to tame US inflation – for now’.
Figure 1: Inflation expectations have begun to pick up on Fed’s reaction function, more robust recovery, and stimulus
Source: Deutsche Bank Research
In Greening the Supercycle, flow examined the various forces pushing commodity prices higher. And in his 21 February piece for the Wall Street Journal, ‘Inflation Problems Depend on Where You Look for Them’, Jon Hilsenrath offered several “reasons for discomfort”.5
“Tesla’s stock price is up more than 300% in the past year. Copper prices are up 56%. The S&P Case-Shiller Home price index is up 9.5%. Freight prices are up 215%; soybeans, 54%, lumber 117%,” he noted. Hilsenrath reminded readers that the Fed’s inflation target dates back to a 1977 congressional mandate requiring “stable prices”, coupled with maximum employment and “moderate” long-term interest rates. He makes the point that high consumer price inflation meant that “the price stability mandate for many years got most of the attention, and the Fed drove inflation down”.
Yet only in 2012 did the Fed set its preferred inflation target at 2%, as measured by the Commerce Department’s personal consumption expenditures price index over the medium run. “In other words, its measure was the cost of household goods and services,” commented Hilsenrath. Since 2021 this measure has averaged 1.3% per year; well below target. “Critics who warned the Fed’s easy money policies of the 2010s would lead to an inflation surge, a financial bubble and a collapsing dollar turned out to be flat out wrong. All the more reason to keep interest rates exceptionally low today, when the economy is struggling, the Fed’s thinking goes.”
However, as society has become more affluent, more resources have been diverted into assets such as stocks, bonds and second homes, he concludes. And while US consumer prices remain subdued, “asset prices march higher, creating new risks that could sideline the economy in unexpected ways."
Past and future
Figure 2: Price series for all countries with continuous data back to 1900 on a log scale. Ordered highest (Brazil) to lowest (Switzerland) over the period
Source: Deutsche Bank, GFD. Note: Data is rebased at 1900 for all countries.
Asset prices were reviewed by Reid back in September 2018 in his Deutsche Bank Research study The History (and Future) of Inflation. He observed that before the 20th century prices generally crept higher only very slowly over time, often remaining flat for long periods. As per Figure 2 that has changed since 1900 and the US, along with Canada, the Netherlands, Switzerland and the UK are the only five out of 25 countries surveyed to have experienced average annual inflation of 3% or less over the period.
Reid revisited the study recently, noting that change in the 20th century reflected a unique explosion in the world population and a regular breaking of ties with precious metal currency systems until, in 1971, they were abandoned completely across most of the world.
While the inflationary effect of a big population boost isn’t about to be repeated, the working age population in both the West and China is set to decline, which may help labour reclaim lost power and provide an inflationary effect. While some expect new, emerging technologies to offset this, ultimately inflation “will likely depend on how aggressive monetary and fiscal policy are and whether they work together consistently.
“In the post-GFC decade, they worked in opposite directions, but the early signs post-Covid are that they are moving more in the same direction. A fiat currency system allows such an experiment if the policy makers decide to go down that route. All eyes are on the US stimulus package(s) and the Fed over the coming months and quarters.”
“Inflation in a fiat currency world is a political choice”
A pointer to the future
In their February 2021 report, US Inflation Outlook: Health care tailwind presents upside risk to Fed’s near-term inflation forecasts, Deutsche Bank Research’s US economists highlight a further warning signal in January’s generally benign US inflation data. The producer price index (PPI) was “robust” and most notably “health care PPI rose a near-record 93bps month-over-month, pushing the year-over-year rate to its highest level since 2007,” they note.
While the spike might prove only temporary “beyond 2021, as the boost from health care fades, our baseline forecast anticipates that inflation will slip below target early next year. But as the economy fully recovers, boosted by easy financial conditions and fiscal stimulus, we expect inflation to more sustainably overshoot the Fed’s target in 2023.”
Figure 3: Inflation to reach Fed’s target by end of 2021, though not consistently. Modest overshoot in 2023
Source: BEA, BLS, Haver Analytics, Deutsche Bank Research
Figure 4: Professional forecasters beginning to see higher inflation risks
Source: Deutsche Bank Research
The team returned to the theme in the February 23 paper US Economic Perspectives: Further fiscal infusion fuels rapid return to full employment, noting that over the longer-term, muted inflation expectations should help to keep actual inflation close to the Fed's target although “the size and scope of the fiscal stimulus that the Biden Administration envisions raises the risks of large positive output gaps and thus the balance of risks to inflation have more clearly shifted to the upside.” This is not yet cause for alarm – although inflation expectations have risen they are still below those of pre-2014, when the price of oil fell sharply – but should they begin to spike up “that could be somewhat of an early warning signal for Fed officials.”
“The Fed … will take into account inflation shortfalls (or overshoots) over longer time periods when setting monetary policy”
Downplaying the risk
Also sounding the alarm on inflation is Irwin Stelzer economist and director of the Hudson Institute's economic policy studies group. Writing in the London Sunday Times of February 28, he focused on Powell’s comment that the Fed will “look through” periods of rising prices “and not react if we see small, and what we would view as very likely transient effects on inflation.” Stelzer noted that this apparent lack of concern is shared by Joe Biden and his Treasury secretary, Janet Yellen. “Each key player has reasons to pooh-pooh the inflationary risks,” he suggested.
According to Stelzer, the new President empathises with the pain of the jobless, ruined business people, hungry children and those in mortgage and rent arrears. If getting help to them “requires tossing benefits to political allies and deploying a shotgun approach that sends US$1,400 cheques even to cash-flush consumers who have not lost their jobs, so be it.” Yellen shares his sentiments and is “unshaken by the recent uptick in the rate on 10-year treasuries to above 1.6%” for the first time since the pandemic began. She is confident that interest rates will remain low enough to “keep tolerable” the cost of servicing the nation’s US$28trn debt “and that the Fed she once chaired has the tools to contain inflation.”
The next meeting of the Federal Open Market Committee (FOMC) on 16-17 March marks the start of Powell’s final year as Chairman – his term expires in February 2022 – and will indicate whether his doveish approach will be maintained.
Deutsche Bank Research reports referenced
Early Morning Reid – Macro strategy by Jim Reid (1 March)
US Economic Perspectives: Managing Inflation Expectations by Justin Weidner, Matthew Luzzetti and Brett Ryan (17 February)
US Inflation Outlook: Health care tailwind presents upside risk to Fed’s near-term inflation forecasts by Justin Weidner, Matthew Luzzetti, Brett Ryan and Suvir Ranjan (17 February)
US Economic Perspectives: Further fiscal infusion fuels rapid return to full employment by Justin Weidner, Matthew Luzzetti, Brett Ryan and Amy Yang (23 February)
Focus Germany: German pent-up demand to boost growth in summer 2021 by Marc Schattenberg (1 March)
1 See https://bit.ly/3e4HDYl at federalreserve.gov
2 See https://bit.ly/386kaT3 at bankofengland.co.uk
3 See https://bloom.bg/3sJQJhb at bloomberg.com
4 See https://on.wsj.com/3c2ce6t at wsj.com
5 See https://on.wsj.com/3sF8Pku at wsj.com
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