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Summary :
- As the global economy gradually recovers from the coronavirus crisis, the expected recovery is likely to be uneven, with varying consequences for inflation.
- In the short term, countries where fiscal and monetary responses have been most substantial are, according to economic theory, at greater risk of seeing inflation rates rise in the future.
- In the longer term, structural changes could have a widespread impact on inflation.
Usefulness of the article: This article analyzes the potential factors behind a rise in inflation in various countries after several years of deflationary pressures, both in the short term as part of the post-coronavirus economic recovery and in the longer term.
For the first time in over a year, inflation has become the risk most frequently cited by investors surveyed in the Bank of America survey published in March 2021, surpassing coronavirus-related risks for the first time since itsemergence. Concerns have also emerged in economic surveys and financial markets, while media coverage of this risk has intensified.
Against a backdrop of considerable uncertainty surrounding the post-pandemic economic recovery, inflation risks could weigh on consumer and investor confidence and thus on the rebound in activity that is beginning to emerge. At present, inflation remains well below the inflation targets of central banks in the world’s major economies. Apart from exceptional situations of war (e.g., Yemen) or major economic instability (Venezuela), most economies are enjoying historically very moderate inflation.
However, it is noteworthy that recent inflation data suggest an acceleration in global price increases: in April, the annual inflation rate stood at 4.2% in the United States, compared with an average of 1.2% in 2020; in the eurozone, it was 1.6%, compared with an average of 0.3% in 2020. Although part of this acceleration can be explained by higher energy prices, core inflation rates, based on a price index excluding energy and food, are also higher overall than in the previous year.
After several years characterized by fears of disinflation or even deflation since the 2008 financial crisis, followed by the deflationary recession caused by the coronavirus, concerns are tending to reverse as new inflation data is released. In the financial markets, this has led to a rise in the prices of certain products offering protection against inflation, such as TIPS (Treasury Inflation-Protected Securities), compared to their nominal value equivalents. This can be seen in particular in the rise in the breakeven inflation rate to nearly 2.5% in April, the highest level since 2013, which results from a comparison between the nominal 10-year US bond rate and the inflation-indexed rate. This means that investors favor products whose returns are protected from inflation, implying that they anticipate future price increases that will reduce the real return on assets.
1. An expected rise in inflation in the short term linked to the post-Covid growth rebound
1.1 The mechanical effects of economic normalization
Part of the rise in inflation rates can be explained by the effects of economic disruptions linked to the coronavirus crisis. Political decisions to restrict mobility, or even impose lockdowns, led to the closure of the economy in many countries. These measures caused a sharp contraction in global economic activity, creating deflationary pressures due to a widespread decline in demand.
The lifting of certain restrictions has allowed for a partial resumption of some activities compared to the initial lockdowns in March 2020, thereby enabling prices to normalize. Lockdown easing is expected to accelerate in 2021, leading to a more widespread recovery that will particularly benefit the service sector. Thus, while prices rose only slightly or even fell last year, this year they are expected to grow in line with the economic recovery. Due to base effects, this normalization will automatically lead to higher inflation rates, which should be observed in all economies that experienced a slowdown in prices last year.
Another phenomenon linked to base effects, which is more local in nature, is expected to impact the inflation outlook in the coming months in Germany and, by extension, in the eurozone. The temporary reduction in VAT in Germany between July and December 2020, which was intended to supportconsumption, after having had a negative effect on inflation, is expected to automatically produce the opposite effect in the second half of 2021.
Source: Federal Reserve Bank of St. Louis, BSI Economics
The shaded period represents the period during which VAT was reduced in Germany (July 1, 2020 to December 31, 2020).
In addition, the economic contraction in 2020 generated a negative shock in demand for raw materials, particularly oil, which continues to have a significant impact on overall price levels. After starting 2020 at around $65, the price of Brent crude fell below $20 in April 2020, its lowest level in nearly 20 years, and remained relatively low throughout the year. The decline in demand and the fall in oil prices therefore led to a sharp drop in inflation rates from March onwards.
With the normalization of the economy, the effect of oil prices is now having the opposite effect. Indeed, the significant rise in prices since the beginning of 2021 (+30% as of May 18, 2021, to $69.5 per barrel) is now translating into an increase in the general price level, unlike last year. For example, while the inflation rate in the eurozone stood at 1.3% in April 2021, the energy price inflation rate jumped to 4.3%. This phenomenon can be observed globally, as energy prices are traded on international markets.
Source: Federal Reserve Bank of St. Louis, BSI Economics
Finally, other phenomena linked to the recovery in economic activity have recently increased upward pressure on production costs. On the one hand, in recent months, a shortage of containers has led to a sharp increase intransport costs. The United Kingdom is particularly vulnerable to this, as it combines with the impact of Brexit on the costs of exporting and importing to and from the European Union since January1, 2021. On the other hand, a shortage of semiconductors is expected to cause production delays for many sectors around the world. If this persists, prices may also rise to compensate for the decline in supply.
1.2 Inflationary fiscal stimulus?
Beyond the expected normalization, which should result in a mechanical rise in inflation rates in the short term, prices could also come under additional upward pressure due to the various measures that authorities have put in place in response to the coronavirus crisis. The scale of the fiscal stimulus packages introduced in most economies to limit the recession should impact prices by allowing demand to recover.
Faced with a recession of historic proportions, fiscal measures have been unprecedented in order to limit the losses associated with restrictive measures and to support demand despite the many uncertainties. Fiscal support and stimulus plans have varied across economies, depending on their fiscal response capacity, the magnitude of the shock they have experienced, but also on their composition, between new spending and support via loans and share purchases.
Government responses to the coronavirus crisis (as a percentage of GDP in 2020)
Source: IMF
With fiscal responses to the crisis on average significantly greater in advanced countries than in emerging and developing countries, the former are likely to experience a stronger rebound in domestic demand, which could translate into higher inflationary pressures. The third US stimulus package, for example, passed in March and worth $1.9 trillion, is a source of concern because a significant portion (22%6) of this amount is being distributed directly to the population with little differentiation based on income, raising fears of a parallel increase in demand.
After limiting the economic damage caused by restrictive measures, the various stimulus plans should enable economies to accelerate their recovery and reduce output gaps (actual output relative to potential output) and thus unemployment rates, which have risen since the start of the crisis. According to economic theory, this phenomenon should lead to an increase in inflation. The reduction in the output gap thanks to stimulus plans should lead to a fall in unemployment rates. The resulting pressure on the labor market should lead to higher wages and, ultimately, higher prices.
1.3 The future of monetary policy
In the short term, the actions of monetary authorities could also lead to an acceleration in inflation. The intensification of asset purchase programs by the major central banks, imitated to a lesser extent by some central banks in emerging economies, has led to a considerable increase in the amount of money in circulation in the global economy. Until now, these measures have barely prevented deflation and have mainly led to a significant rise in financial asset prices. However, due to their amplification in response to the pandemic, some fear the effects of these measures on consumer prices.
However, these fears, which stem from the quantity theory of money, seem unjustified given the limited impact that ultra-accommodative policies have had on prices in recent years, particularly in Japan, where the combination of strong money supply growth and low interest rates since the 1990s has had no significant effect on inflation.
Emerging countries generally benefit from low interest rates in developed countries, as they can attract investors by offering higher yields. Consequently, the rise in long-term rates in the United States raises the risk of a reversal of this trend, as seen in the « taper tantrum » of 2013, although no such movements have been observed to date. The risk of capital outflows is accompanied by risks of currency depreciation, which could lead to an increase in imported inflation. Some emerging countries appear particularly vulnerable due to their dependence on foreign capital inflows (Brazil, Turkey, Nigeria) and their already high interest rates (Argentina, Turkey), leaving them little room for maneuver to increase their attractiveness without hampering economic activity.
2 Risk of long-term inflation
2.1 Inflation to ease debt?
While short-term inflationary pressures are likely to prove transitory in the world’s major economies, other factors could have an impact on inflation in the longer term. These include high levels of debt, particularly public debt, which have worsened as a result of the coronavirus crisis.
The public debt ratio has increased by more than 15 percentage points in developed countries and between 5 and 10 points in emerging countries, putting some economies in a vulnerable fiscal position. However, debt is a stock that carries over from year to year and there are few opportunities to reduce it significantly:
· Strong real GDP growth: unrealistic at this stage, particularly in developed countries (excluding the United States), due to the downward trend in growth rates;
· Fiscal consolidation, which is unlikely in the short term and politically unpopular;
· Default, which is unthinkable in most countries;
· Higher inflation, allowing for a reduction in real debt.
The last option therefore seems the most realistic in the current context and could encourage political governments to put pressure on monetary authorities to maintain their ultra-accommodative stance in the face of rising inflation, which would enable them to reduce their debt. For their part, central banks could also find this practice of « fiscal dominance » beneficial, allowing them to focus on reducing unemployment rates at the expense of inflation. The change in the Federal Reserve’s (Fed) inflation target in the United States, which now aims for an average inflation rate of 2%, suggests that this is a possibility.
However, the risk of fiscal dominance is not equally likely everywhere. Most developed countries have an independent central bank with a specific mandate, which limits the risk of interference between governments and monetary authorities. In contrast, in some countries, particularly emerging economies, the absence of this strict separation can lead to suboptimal monetary policy situations. Turkey is a recent example of a central bank whose independence is increasingly being called into question. Thus, countries where central bank independence is not guaranteed are at greater risk of rising inflation linked to an inappropriate monetary policy response.
2.2 Demographics and the labor market
In the longer term, structural changes may also alter the inflationary threats to economies. Current demographic trends are likely to generate excess inflation in the coming decades, as Charles Goodhart and Manoj Pradhan explain.
For several years now, declining birth rates, particularly in developed countries, have led to a decrease in the working-age population. Combined with an aging population, which means that a growing proportion of the population is retiring each year, this is likely to lead to a decline in the global labor supply. The decline in the number of workers will give them greater bargaining power, enabling them to exert upward pressure on real wages and therefore on production costs. As for the increase in the proportion of the population that is dependent relative to those of working age, this is likely to lead to an increase in consumption relative to production, which should also push prices up.
The main countries affected are Western countries with aging populations, as baby boomers gradually retire. China is also affected by this phenomenon, due to its low population growth in recent decades.
Source: United Nations, BSI Economics
Beyond the aging population, other phenomena are contributing to the decline in labor supply: after nearly 30 years, the integration of certain economies into the global system is reaching its conclusion. As a result, the decline in production costs linked to the positive supply shock caused by the opening up of China and the former Eastern Bloc countries is now slowing down (although unit labor costs remain relatively low in most emerging countries).
Similarly, the integration of women into the labor market in Western economies appears to have plateaued and is now expected to stabilize. The combination of these phenomena signals the end of the largest positive labor supply shock at the global level. The slowdown in labor supply should therefore translate into increased bargaining power for workers and thus higher wages, which should lead to higher costs that will be passed on to prices.
Conclusion
If inflation were to materialize beyond the peaks expected in 2021, other related risks would need to be taken into account. Investors’ fears are linked to the prospect of interest rates rising due to a change in central banks’ monetary policy, using the means at their disposal to fulfill their price stability mandate. The expected consequences would be an economic slowdown through a decline in credit, a decline in employment, and possibly a negative shock to financial assets, which have been boosted by cheap money in recent years.
In the longer term, if inflation were to persist beyond central bank targets, consumer and investor confidence linked to price uncertainty would also weigh on growth.
However, these assumptions are based on a set of relatively optimistic projections that are themselves uncertain. In the context of the post-coronavirus economic recovery, many unknowns remain to date regarding the timing of the lifting of measures, the possible resurgence of the virus due to variants, the future of medium-term budgetary decisions, oil supply decisions by producing countries, decisions on the potential relocation of production lines for goods considered strategic, etc. The uncertainty is undeniable and could tip the current outlook.
References
4. https://www.politico.eu/article/shipping-container-shortage-hits-global-trade-freight-prices/
6.https://www.wsj.com/articles/whats-new-in-the-third-covid-19-stimulus-bill-11615285802
7. https://www2.deloitte.com/xe/en/insights/economy/asia-pacific/china-supply-chain.html
Fiscal Monitor Reports, Fiscal Monitor April 2021, April 2021
Andy Haldane, Inflation: A Tiger by the Tail?, February 26, 2021
Pinter, J. (2021), Monetarist arithmetic at Covid-19 time: a take on how not to misapply the quantity theory of money
