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What a Spotlight on inflation past and present tells us about future risks

Last week we launched our annual CE Spotlight series, which is an opportunity to step back from the day-to-day ebb and flow of the data and take an in-depth look at the key issues that will shape the outlook for the global economy and financial markets. This year we are exploring whether the world is witnessing the rebirth of inflation. (Clients can access the Spotlight series as part of their subscription, and can view all publications and register for online discussions with our economists here.)

The series kicked off with a piece by Marcel Thieliant and Jack Allen-Reynolds that examined how long the inflationary effects of the pandemic will last. They identify three channels through which the pandemic has pushed up inflation this year. The first is a rebound in global commodity prices. The second is a rise in prices caused by frictions as sectors reopen from lockdowns. And the third is the emergence of goods shortages as global supply has struggled to keep pace with a surge in demand for some consumer durables during the pandemic. 

Our analysis suggests that around nine-tenths of the rise in inflation in advanced economies this year has been driven by these three things, with six-tenths being caused by the rebound in global commodity prices alone. The key point is that all of these drivers of inflation are, to borrow the words of Fed Chair Jerome Powell, likely to prove “transitory”. Energy inflation is either peaking or close to peaking in most countries and should fall over the course of next year. Likewise, reopening frictions should ease over the coming months. And while goods shortages are likely to linger into 2022 as inventory is rebuilt along supply chains, there is evidence that the most acute price effects – for example in the US auto sector – are now moderating

The upshot is that the increase in inflation experienced as a direct result of the pandemic is close to peaking. We expect headline inflation to fall back in every major advanced economy in 2022. 

Instead, the more important question is whether the pandemic marks the start of a new era of sustained higher inflation over the medium-term. As Vicky Redwood argued in her Spotlight piece, one way in which this could happen is if the response to COVID paves the way for a prolonged period of much stronger aggregate demand

There are several reasons to think this is possible. For a start, the scale of policy support during the pandemic has left consumers with considerable “excess” savings. This creates the potential for a surge in private spending if these savings are subsequently run down. At the same time, the huge increase in commercial bank reserves over the past year could result in a post-COVID credit boom as economies recover and lenders and borrowers become more confident. And the structural changes wrought by the pandemic could act as a spur to demand – for example, by unleashing a wave of investment in the digital economy. 

In the first instance, a rebound in demand will be absorbed by any remaining spare capacity in economies. And although economies are experiencing frictions as restrictions to contain the virus are lifted, we remain more optimistic than most about the extent to which the pandemic has damaged supply potential. But it’s possible that demand will remain strong even once economies return to full employment, potentially fuelling inflation. The risks are particularly acute in the US, where the scale of policy support has been particularly large, “excess” savings are especially high, and output is already much closer to its pre-crisis trend than in other countries. 

However, inflation outcomes will be determined by other factors too. As Simon MacAdam argued in his Spotlight piece, one important lesson from history is that periods of higher inflation have only emerged when central banks and governments have allowed them to. Accordingly, we need to take into account the likely response by policymakers – and the potential for this to be influenced by shifts in attitudes towards inflation – when thinking about the future path of inflation. We also need to consider how the structural forces that underpinned the low inflation era of the past three decades are changing. These issues will be the focus of this week’s Spotlight pieces. 

In case you missed it:

  • Our Chief Asia Economist, Mark Williams, argues that the deepening crisis at Evergrande will be followed by a lasting decline in China’s property sector.
  • Our Commodities Economist, Kieran Clancy, argues that natural gas prices are likely to remain high well into 2022.
  • In 'Mapping decoupling', our Senior China Economist, Julian Evans-Pritchard, looks at which countries are likely to align with the US and which are likely to align with China.