Of all the questions that hang over the post-COVID world, the most important for financial markets is whether the pandemic will mark the start of a new era of higher inflation. Yet much of the debate over inflation remains muddied and confused, and many of the important nuances between different countries are often overlooked in the search for an overarching narrative.
We’ll be addressing whether this is the rebirth of inflation in CE Spotlight, a new series of in-depth research reports and accompanying online client events designed to cover all aspects of the inflation question – from the lessons of history to the role of policymakers to the impact of US-China decoupling.
A key motivation for launching CE Spotlight is that much of the discussion around inflation has tended to focus either on the impact of the pandemic on global supply chains, or the huge amount of policy support that has been provided by governments and central banks. Both are important, but this rather narrow approach lacks both historical context and any consideration of the myriad social, economic and institutional influences on inflation.
One way to think about whether we are now witnessing the “rebirth” of inflation is to consider the causes of its “death” in the preceding decades. Broadly speaking there were three.
The first was a huge expansion in supply potential at a global level. The most important aspect of this was the integration of China into the world trading system. But it was also underpinned by new technologies that, for example, enabled the fragmentation of supply chains, as well as a wave of liberalising reforms that led to a more general intensification of competitive pressures.
The second factor was a determination by governments and central banks to bear down on inflation itself. This played out in different ways in different countries. But a key element was that decisions over monetary policy were made separately from government by newly independent central banks, and very often in strict accordance with inflation targets. Policy was set in a restrictive way if necessary, which both brought down inflation but also anchored inflation expectations at lower levels.
The final cause was a structural change in wage- and price-setting behaviour. Price controls were abandoned, and a combination of labour market liberalisation and de-unionisation reduced workers’ bargaining power. This helped to break the wage-price spirals that fuelled a rise in inflation in the 1970s and set it on a lower path.
All of these factors then fed off one another in a mutually reinforcing way to produce the era of low inflation that has been a hallmark of the global economy over the past three decades. But some of the key pillars of the low inflation era are now starting to weaken.
The huge expansion of global supply potential has slowed. Globalisation has peaked and in some ways is reversing, and demographic changes are weighing on labour force growth in many advanced countries. More fundamentally, at some point it is always possible to overwhelm supply with demand. The possibility of this happening has increased substantially following the large build-up of private savings and huge fiscal expansions seen during the pandemic. The risks are particularly acute in the US.
The attitude of governments and central banks is also shifting. After a decade in which deflation has posed a greater threat than inflation, the imperative to continue bearing down on inflation has diminished. Indeed, there are several reasons why policymakers might want moderately higher inflation. 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. And higher inflation also helps to erode the real value of public debt, which has risen sharply because of the fiscal support provided during the pandemic.
The Fed has already shifted to an average inflation target and is putting more emphasis on the “full employment” part of its dual mandate. It remains to be seen what this means in practice, or whether other major central banks will follow in the Fed’s footsteps. But at face value this appears to be a break from the past – and more radical changes to policy frameworks could follow.
However, many of the structural factors that created the low inflation era will also 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.
What emerges from all of this is a debate that 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.
We think this nuance – currently missing from the highly-polarised debate about inflation – will be crucial for investors navigating the post-pandemic economy.
CE Spotlight reports and event registration will be available for free to Capital Economics clients on our website from Monday 13th September.
In case you missed it:
- Our Chief Asia Economist, Mark Williams, takes stock of the tech clampdown in China.
- Our Chief Europe Economist, Andrew Kenningham, argues that the ECB could set out plans to taper asset purchases at this week’s meeting.
- Our Chief Markets Economist, John Higgins, looks at the prospects for long-run equity returns in the context of current high valuations.