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MACRO RESEARCH
16 March 2021

The Return of Inflation

Inflation is back on investors’ radars. Commodity prices have increased sharply over the last several months and emerging bottlenecks across supply chains should cause producer prices to rise more rapidly over the next few months. Still, recent comments by Janet Yellen and Jay Powell indicate that policy support will remain ample for the time being. Indeed, for the new US Treasury secretary, “the smartest thing we can do now is act big”. And according to the Fed Chairman, monetary policy will have to remain “patiently accommodative”.
Producer prices are on the rise
producer_prices_on_the_rise.png
Source: Macrobond, Bank J. Safra Sarasin Ltd, 19.02.2021
Democrats in Congress are moving ahead with the USD 1.9 tn American Rescue Plan. This, combined with the USD 900bn Response and Relief Act passed late last year, means that the amount of fiscal support this year will amount to about 12% of GDP. Official estimates imply that the output gap – the difference between what the economy is capable of producing and what it actually is producing – is around 3% of GDP. The combined fiscal packages will inject an average of close to USD 300bn per month into the economy till end-September, against an estimated monthly output gap of USD 80bn. Therefore, if the demand for goods and services exceeds supply, prices should go up. But by how much? And how sustained will the increase in inflation be? To answer these questions, we need to distinguish between short-term and longer-term dynamics.

US fiscal policy will inject around USD 300bn per month into the economy throughout the end of September against an estimated monthly output gap of USD 80bn. Too much money chasing too few goods should be inflationary

This year, it’s all about the base
Over the next several months, large positive base effects will shape advanced economies’ inflation profiles. The sharp increase in commodity prices will directly feed through to headline inflation. In the US, the contribution from the energy component is likely to add to about 1 percentage point to inflation in the first quarter. Around springtime, the contribution from items, such as airline and hotel room fares, that saw large price discounts due to tight restrictions this time last year will turn positive once again.
Indeed, there is a high chance that demand for services we have not been able to enjoy over the past year will rebound vigorously as the economy reopens, pushing their prices higher. Consumption by high-income households in the US remains depressed compared to pre-pandemic levels, while the accumulated excess savings could reach around USD 2tn later this year. Similar dynamics can be observed in other advanced economies.
Base effects to peak in May
base_effects_peak.png
Source: Macrobond, Bank J. Safra Sarasin Ltd, 19.02.2021
Other parts of the basket that have benefited from the pandemic, such as used cars, will provide some offset as prices should normalise to the downside as well. All in all, these different base effects should peak in spring and add another 1 percentage point to US headline inflation. We expect core CPI inflation to peak at about 2.5% in the second quarter, and headline inflation to top at around 3.5%. Clearly, there is scope for inflation to overshoot our forecasts as big price increases for some goods and services might be necessary in order to balance demand with available supply, which the pandemic will likely have diminished. Still, inflation is likely to fall in the second half of the year as these effects drop out of the year-on-year price comparisons.

Large base effects should push US inflation to around 3.5% in spring. We wouldn’t be surprised to see even larger price increases

Underlying inflation should trend higher
The real question is whether this episode will be a one-off price level adjustment or whether we should expect a more sustained increase in inflation. Clearly, after a quarter of a century of subdued inflation, it is tempting to argue that there is no need to worry. After all, the true level of unemployment in advanced economies remains extremely high, and for inflation to remain sustainably higher, we need to see stronger wage dynamics. This is unlikely to happen until strict social distancing measures are comprehensively lifted. But once they are, we think that US inflation is more likely to be above 2% than at any time in the last 25 years. Inflationary pressures are likely to build in other advanced economies too, but probably to a lesser extent.
There are three reasons supporting our view. First, as already mentioned above, the amount of monetary and fiscal support recently provided has been unprecedented. US broad money supply, which to a large extent reflects households’ and corporates’ cash and savings deposits at banks, picked up by around USD 5tn in 2020, a quarter of the existing money stock. In the euro area, it increased by EUR 1.5tn. This is very different to what happened after the Global Financial Crisis, when the expansion of the balance sheets of central banks boosted banks’ reserves, but only led to a modest increase in money supply, as banks were reluctant to lend to the real economy. Of course, if policy support were swiftly removed, that would only result in a period of higher inflation that eventually tails off, in line with a drop in the purchasing power of money.
However, and this brings us to our second point, policy support should be phased out only very gradually. The Fed will aim to overshoot its target for some time before raising rates. QE tapering will be gradual and will not happen before ‘substantial’ progress has been made towards achieving its goals. Other central banks are likely to mimic the Fed. On the fiscal front, with the “American Rescue Plan” signed into law, the US government will focus on a large ‘recovery’ bill in order to increase public spending on infrastructure. In short, the US output gap should close rapidly, and the economy could already be back at full employment by the end of 2022. Wages are likely to rise sooner and faster than many investors expect. From a monetarist perspective, these policies should push the velocity of money higher, boosting inflation. European fiscal policy will probably be less expansionary, but a return to austerity, as it happened after the financial crisis, is unlikely.
Wages could pick up faster than anticipated
wages_pick_up.png
Source: Macrobond, Bank J. Safra Sarasin Ltd, 19.02.2021
Monetary and fiscal authorities should also continue to work closely together. The experience from the crisis has shown that monetary and fiscal policy can be very good complements and can create policy space for both. This should help restore central banks’ credibility in achieving their inflation target, and boost long-term inflation expectations.
Finally, structural changes should become more inflationary over the longer term. Work by multinational institutions shows that two interrelated factors – a weakening of trade unions and the huge increase in global labour supply following the entry of China into the WTO and Eastern Europe into the EU – appear to have dampened the relationship between economic slack and inflation in advanced economies over the past decades.

A strong cyclical recovery, prolonged policy support and structural changes should lead to a more sustained increase in inflation than economies have experienced over the past decades

These deflationary forces should slowly abate. The pandemic has exacerbated already large income and wealth inequalities, and policies will increasingly be geared towards closing that gap. President Biden is pushing for a doubling of the minimum wage (spread over several years) and aims at boosting wage bargaining power via stronger unions. The ageing of the population in the developed world and China implies that a larger number of people will have to work in the care industry, creating labour shortages and boosting the bargaining power of workers in other industries.
To sum up, over the next two years we expect much stronger real GDP growth as the pandemic fades and households spend their vast amount of accumulated savings. This is especially true in the US. Inflation should also pick up more rapidly than in previous recoveries, and we expect US core PCE inflation to overshoot 2% by the end of 2022. Euro area inflation is not expected to get to 2% before 2023. Strong nominal growth should support risk assets, but the ability of the Fed to guide markets as it gradually removes its monetary accommodation will be crucial.

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