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Inflation’s complex outlook depends on shifting attitudes in corridors of power

The record surge in gas prices, which has gripped markets and dominated headlines in recent weeks, is also helping crystallise fears that the global economy is facing a generational shift towards higher rates of inflation. 

Although we think gas prices will retreat by spring next year, other factors are at play which could sustain inflation in the post-COVID global economy. We are examining these in CE Spotlight, a series of in-depth reports and online events designed to tackle the question of whether we are witnessing the rebirth of inflation. 

The main message from the initial reports in this special series was that, while the direct effects of the pandemic on inflation were likely to be transitory, a post-COVID surge in demand could pave the way for a period of higher inflation in some countries. And last week’s Spotlight publications showed how some of the structural forces that contributed to the “Death of Inflation” in the 1990s and 2000s are now either easing or reversing. 

The various ways in which these structural disinflationary forces are unwinding are, by now, well known. Globalisation has peaked and US-China decoupling could contribute to a rise in inflation pressures in some sectors; demographics have gone from exerting downward pressure to upward pressure on inflation; and firms will face new costs – including to green economies.

However, as Michael Pearce argues in his Spotlight piece, many of the structural factors that created the low inflation era will persist: labour markets remain highly flexible, workers’ bargaining power remains limited, and inflation expectations remain well anchored at low levels. What’s more, new disinflationary forces are emerging: new technologies will continue to bear down on capital goods prices, and the development of the gig economy and remote working points to even greater labour market flexibility in some sectors.

Analysing how these structural forces will trade off against one another over time is impossible. However, a key lesson from history is that periods of higher inflation have only emerged when policymakers have allowed them to. With this in mind, the most important point made in Michael’s piece is that the attitude of governments and central banks in some countries is starting to shift. The laser focus on containing inflation that has dominated central bank thinking for the past forty years is beginning to ease and in some countries it is giving way to a greater tolerance of higher rates of inflation. 

There are several reasons why policymakers might want moderately higher inflation. For a start, it’s easier for relative prices to adjust in real terms in an environment of higher inflation, which may be particularly helpful given the structural changes wrought by the pandemic. What’s more, higher inflation also helps to erode the real value of debt. Public debt ratios have risen substantially because of the fiscal support provided during the pandemic. Governments may try to recreate the conditions after World War Two, in which moderately higher rates of inflation helped to reduce the burden of public debt accumulated during the war.

The problem, as David Oxley and Stephen Brown argue in their Spotlight piece, is that once inflation gets to a certain rate it also creates significant economic costs. It distorts the allocation of resources, restrains savings and investment, and makes it more difficult for companies and workers to plan for the future. 

It’s difficult to be precise but our analysis suggests costs become more severe once inflation rises above 5%. So while some governments and central banks may become increasingly comfortable with inflation rates of 3-4%, none are likely to willingly allow it to accelerate to 5% or more. This implies that if inflation does rise to such rates then it will be because policy mistakes inadvertently allow it to do so. 

Accordingly, the debate isn’t as simple as whether inflation remains dead or not. Inflation outcomes will be determined by a complex set of forces and policy choices – some of which will be intentional, others of which may not. This is all likely to play out in different ways in different countries.

One way to think about this is to put countries into different inflation buckets. The first contains countries where inflation remains dead (i.e. at rates of 2% or below). The second contains those countries where inflation accelerates to moderately higher rates of 3-4%. And the third contains those where inflation rises to substantially higher rates of 5% or more.  

If a period of higher inflation is to emerge in an advanced economy, it is most likely to be in the US. The scale of the stimulus and the speed of the recovery there has been greater than elsewhere, and the Fed has adopted a new, more tolerant, approach to inflation. The UK and Canada are also at risk of a period of higher inflation, although the case is less clear-cut than in the US. All three countries sit in the new “moderately higher” inflation bucket. 

In contrast, the euro-zone sits in the “inflation still dead” bucket. The ECB has so far shown no willingness to embrace the Fed’s greater tolerance of inflation, and in any case the structural disinflationary forces are much greater in the euro-zone. The same is true of Japan, Switzerland and Sweden. 

No country sits in the third “significantly higher” inflation bucket. Given the costs associated with much higher rates of inflation, this outcome is only likely to arise as a result of unintended policy mistakes. As things stand, the risks are greatest in the US and the UK.  

The key for asset markets is what happens to real interest rates throughout all of this. In our view, real rates are likely to remain negative in all major advanced economies over the next 3-5 years – either because economic conditions and the inflation outlook warrant negative real rates (euro-zone/Japan) or because policymakers set real rates low and tolerate any pick-up in inflation (US). Either way, this should support risky asset prices. 

The question beyond the next few years is what happens once the inflation genie is let out of the bottle? How far will real rates have to increase if and when policymakers in the “moderately higher” bucket of countries want to bring inflation back down – or if inflation continues to rise to more uncomfortable rates? We’ll tackle this, and the implications for financial markets, in next week’s Spotlight pieces. 

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