Fragile demand to keep underlying inflation subdued - Capital Economics
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Fragile demand to keep underlying inflation subdued

Global Inflation Watch
Written by Jennifer McKeown
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Over the next few months, inflation will be dominated by oil price effects as the previous slump unwinds and headline rates rise from their current lows. Some components of core inflation, such as airfares and restaurants, could recover lost ground as containment measures ease. But in general, the impact of weak demand will dominate. It will be some time before world GDP reaches its pre-virus path and incomes are set to suffer as government job retention schemes and other support measures are wound down. Central banks’ generous support measures are more likely to put a floor under inflation than to boost it significantly, at least over the next couple of years. In all, we now expect core inflation to be somewhat weaker than we anticipated before the virus and see headline rates settling below central banks’ targets.

  • Table of Key Forecasts
  • Overview – Over the next few months, inflation will be dominated by oil price effects as the previous slump unwinds and headline rates rise from their current lows. Some components of core inflation, such as airfares and restaurants, could recover lost ground as containment measures ease. But in general, the impact of weak demand will dominate. It will be some time before world GDP reaches its pre-virus path and incomes are set to suffer as government job retention schemes and other support measures are wound down. Central banks’ generous support measures are more likely to put a floor under inflation than to boost it significantly, at least over the next couple of years. In all, we now expect core inflation to be somewhat weaker than we anticipated before the virus and see headline rates settling below central banks’ targets. (See Chart.)
  • Demand and Capacity – While supply potential is recovering, consumer caution will keep demand below its pre-virus path and weigh on price pressures for some time to come. (See page 5.)
  • Labour Markets – Unemployment looks set to settle above pre-crisis rates as government schemes to protect jobs are wound down. This will keep wage growth under downward pressure. (See page 6.)
  • Commodity Prices – Oil prices have bounced back from historic lows and are likely to grind higher in the months ahead, exerting strong upward pressure on inflation over the next year. (See page 7.)
  • Monetary Conditions and Policy – Immense policy stimulus has boosted the money supply significantly, but this is unlikely to boost inflation in the current economic environment. (See page 8.)
  • Inflation Expectations – Investors and economists have focused on the effects of economic weakness rather than policy stimulus and so inflation expectations have generally fallen. (See page 9.)
  • Emerging Markets – EM core inflation is likely to remain subdued at multi-decade lows and food inflation should ease. This will give EM central banks the breathing space to loosen policy further. (See page 10.)

Chart 1: CPI Inflation in Advanced Economies (%)

Sources: Refinitiv, Capital Economics


Forecast Summary

Table 1: Key Forecasts

Average

Forecasts

Year avg. unless o/w stated

2010-2016

2017

2018

2019

2020

2021

2022

Headline CPI Inflation

World (1)

3.4

3.0

3.1

2.8

2.2

2.6

2.8

Advanced economies

1.4

1.7

2.0

1.5

0.6

1.4

1.5

Emerging economies (1)

4.6

3.7

3.7

3.6

3.1

3.2

3.4

US

1.6

2.1

2.4

1.8

1.0

1.9

1.9

Euro-zone

1.3

1.5

1.8

1.2

0.4

1.0

1.3

Germany

1.3

1.7

1.9

1.4

0.5

1.3

1.5

France

1.8

2.3

2.2

1.0

0.6

2.0

1.4

Italy

1.3

1.3

1.2

0.7

0.4

1.2

1.3

Japan

0.4

0.5

1.0

0.5

-0.6

0.4

0.5

UK

2.2

2.7

2.5

1.8

0.8

0.9

1.1

Canada

1.7

1.6

2.3

1.9

0.7

1.9

2.0

China

2.8

1.6

2.1

2.9

1.5

1.5

2.0

India

8.2

3.3

4.0

3.7

4.5

5.0

5.0

Russia

8.2

3.7

2.9

4.5

3.3

3.5

3.3

Brazil

6.8

3.5

3.7

3.7

2.3

2.8

3.5

Core CPI Inflation

US

1.8

1.8

2.1

2.2

1.3

1.5

1.8

Euro-zone

1.1

1.0

1.0

1.1

0.7

0.8

1.0

Japan

0.2

0.2

0.3

0.6

-0.1

-0.4

-0.1

UK

2.1

2.3

2.1

1.7

1.2

1.0

1.1

Real GDP

World (2)

3.6

3.7

3.6

3.0

-5.5

7.7

3.8

Advanced economies

1.8

2.4

2.2

1.7

-8.0

7.5

2.7

Emerging economies (2)

5.1

4.5

4.4

3.7

-4.0

7.8

4.5

US

2.2

2.2

2.9

2.3

-5.5

7.0

3.3

Euro-zone

1.1

2.4

1.9

1.2

-12.0

10.0

1.8

Japan

1.4

1.9

0.8

0.7

-6.4

2.2

1.7

UK

2.0

1.8

1.4

1.4

-12.0

10.0

3.7

Canada

2.1

3.0

2.0

1.6

-7.0

8.0

3.8

China (2)

6.7

5.8

5.4

5.5

-1.0

11.0

4.5

India

7.7

6.9

7.4

5.3

-4.0

8.0

8.0

Russia

1.6

1.6

2.3

1.3

-6.0

4.5

1.5

Brazil

1.4

1.1

1.1

1.1

-8.0

3.5

2.0

Commodity Prices (3)

Latest

Oil (Brent $ pb)

40

67

54

66

45

55

60

Gold ($/oz)

1,762

1,302

1,283

1,517

1,600

1,550

1,500

(1) Excludes Venezuela & Argentina; (2) China estimates based on our China Activity Proxy; (3) End-year, not year average.


Overview

Energy prices will dominate the inflation outlook in the coming year

  • Oil prices have more than doubled since collapsing earlier this year and should now begin to push up headline inflation. Weaker food inflation and subdued rates of core inflation will lessen the boost from higher energy prices only to a limited extent, so headline rates should get back to their 2019 levels in 2021.
  • Energy price effects have knocked a whole percentage point or so off headline inflation in OECD economies in the first half of this year. We expect the Brent oil price only to edge up from its current level to $45pb by year-end. Even so, energy effects are about to swing from a large drag to a large boost. (See Chart 2.)
  • Even with such a big rise in energy inflation, there are unlikely to be major second-round effects on underlying inflation from higher material input and transport costs. (See Chart 3.)
  • Since the virus outbreak, consumer food price inflation has risen in many EMs and has spiked in DMs. (See Chart 4.) As the temporary lift to demand from consumers switching from meals out to more supermarket food as well as supply problems – such as unpicked food during lockdowns – subside, food inflation should ease back. But this will do little to limit the rise in overall inflation from higher energy prices.
  • And it won’t be long before core inflation bottoms out and stops dragging on headline rates once recoveries gain traction. (See Chart 5.) Normally, core inflation responds to slowdowns in demand with a lag of a year or so. But given the scale and suddenness of the hit to demand in some sectors, there have been sharp falls in prices of some items, such as airfares. As economies continue to reopen, many of these price falls should begin to partly reverse, and the drag on core inflation should drop out of the year-on-year comparison in a year’s time.

Chart 2: Oil Price & Energy Contrib. to OECD Inflation

Chart 3: Average Response of Inflation in Major Advanced Economies to Doubling of Oil Price (%-pts)

Chart 4: Food CPI Inflation (%)

Chart 5: Core CPI Inflation (%)

Sources: Refinitiv, OECD, Capital Economics

Overview (continued)

Core inflation to stay subdued, probably even beyond the two-year horizon

  • The big picture on underlying inflation, though, is that weak demand should offset inflationary effects of supply constraints and policy stimulus and so keep a lid on core price pressures.
  • In the very near term, lower employment (see Chart 6), lower incomes, and consumer caution should constrain demand for goods and services, so core inflation is likely to fall further to below 1% in most DMs. The recent jump in unit labour costs is likely to prove short-lived, as productivity recovers once people return to work. And, in the meantime, the weakness of demand will prevent firms passing the spike in their costs on to consumers. (See Chart 7.)
  • Unlike in typical recessions, the knock to the supply side of the economy has been bigger this time. Supply chains have been disrupted and social distancing reduces the capacity at which firms, particularly in consumer-facing services, can operate. But rather than boost inflation, we think that these supply factors will just put a floor under how far inflation can fall. As containment measures are lifted, the productive capacity of the economy should bounce back quicker than demand. We have lowered our forecasts for core inflation in advanced economies accordingly. (See Chart 8.)
  • And as for the risk that policy stimulus today will cause inflation to take off in a few years’ time, we are not too concerned at this stage. The surge in lending is covering operating expenses such as rent and bills, rather than funding excessive purchases of goods or services. Further ahead, firms are more likely to consolidate their bloated balance sheets than embark on an inflationary spending spree.
  • Finally, higher commodity prices will be the main factor behind the recovery in headline inflation in the coming years. (See Chart 9.)

Chart 6: Employment in DM Economies (Millions)

Chart 7: Unit Lab. Costs & Core CPI in DMs (% y/y)

Chart 8: Core CPI Inflation in DMs (%)

Chart 9: Headline CPI Inflation in EMs (%)

Sources: Refinitiv, CEIC, Capital Economics

Demand and Capacity

Drag from weak demand to offset any boost from supply constraints

  • There are three ways in which efforts to contain the virus have restricted the productive capacity of the economy and therefore could exert upward pressure on underlying inflation. First, business closures have been enforced globally, disrupting supply chains, and potentially making production inputs more expensive. Second, lockdowns hit domestic supply in many of the consumer sectors. And third, even as lockdowns are lifted, social distancing limits supply capacity in consumer-facing services.
  • Supply pressures in a socially distanced economy may cause the prices of certain goods or services, such as airfares, to rise significantly after falling sharply in recent months. However, as for core consumer prices more generally, supply restrictions are more likely to put a floor under inflation rather than drive it up.
  • Indeed, the inflationary effects of restrictions can be overstated. So far, merchandise trade has held up much better than we had expected (see Chart 10), which doesn’t sit well with the idea that businesses are struggling to import parts. In any case, most spending items in the core consumer basket are not that sensitive to global supply chains. (See Chart 11.)
  • What’s more, lockdowns and social distancing hit demand at least as hard as they hit supply. Indeed, industrial firms are operating way below capacity. (See Chart 12.) And broader measures of slack were pointing to weaker inflation even before the virus. (See Chart 13.)
  • Further ahead, demand should recover more slowly than supply, so core price pressures should remain subdued. Caution will prevent households from going on a spending spree with the savings they have built up in recent months, while uncertainty and bloated balance sheets should rein in corporate spending.

Chart 10: Global Real Goods Exports to GDP Ratio*

Chart 11: Global Supply-Chain Sensitivity of “Core” Consumption in the OECD (Excl. Food & Energy)

Chart 12: Industrial Capacity Utilisation in Advanced Economies (Standard deviations from period average)

Chart 13: Backlogs of Work Component of Developed Markets Compoitse PMI & DM Core CPI Inflation

Sources: Refinitiv, IHS Markit, Capital Economics

Labour Markets

Weaker pay growth to weigh on core inflation

  • The immediate labour market effects of the virus have been limited by government job protection schemes. But incomes have suffered nonetheless and are set to weaken further as such schemes expire and some jobs are lost permanently. This will weigh on underlying inflation in the months ahead.
  • The virus has had diverse effects on measured unemployment. Unemployment rates have barely moved in the euro-zone, the UK and Japan due to job retention schemes. (See Chart 14.) At 13.3%, the US unemployment rate is almost four times as high as it was pre-virus. But incomes there have been supported by a sharp rise in unemployment benefits.
  • Looking ahead, unemployment will probably rise in the euro-zone, UK and Japan as job retention schemes wind down. And in the US, the rate will fall as laid off workers are recalled. In all cases, though, we expect some permanent layoffs and worker displacement to leave unemployment rates higher than they were before the crisis for some time. (See Chart 15.) After all, some firms will inevitably go bust. And the recent slump in job vacancies bodes ill for hiring. (See Chart 16.)
  • Unit labour costs have risen across several advanced economies as an inability to go to workplaces has led productivity to drop. (See Chart 17.) But this trend will unwind as people return to work and weak demand will prevent firms from passing the rise in their costs on to consumers in the meantime. Household incomes have fallen on aggregate as government transfers and subsidies have not fully replaced salaries. And our forecasts of persistent spare capacity in the labour market will keep wage growth under downward pressure as more people return to work.

Chart 14: Unemployment Rate

Chart 15: Employment Intentions & Job Vacancies
in Advanced Economies*

Chart 16: Unemployemnt Rate Forecasts (%)

Chart 17: Euro-zone Unit Labour Costs

Sources: Refinitiv, Capital Economics

Commodity Prices

Oil prices to add 1.5-2.0%-pts to average inflation in the coming year

  • Compared with our pre-virus forecasts, energy prices appear to have knocked about 1%-pt off average headline inflation in OECD economies in the past few months. But oil prices have now bounced back from historic lows and are likely to grind higher in the years ahead, exerting significant upward pressure on inflation.
  • The recovery in oil prices has come about very quickly. So quickly, in fact, that we suspect that there is limited scope for further big price gains in the near term. Indeed, petroleum demand is still very weak as millions of households in big oil-consuming economies are working from home rather than travelling to work, and global stocks of crude oil remain high. (See Chart 18.)
  • Over the next year or two, though, there is plenty of scope for demand to recover as lockdowns continue to ease around the world. Massive infrastructure spending in China should support industrial demand for energy too.
  • Admittedly, household caution in terms of leisure travel, increased working from home and restricted air travel will mean that energy consumption will be lower than it would have otherwise been for a long time to come.
  • But relatively weak oil demand will be met by lower supply, which should be enough to push the global crude market into a deficit later this year. Indeed, low prices have led to a collapse in US shale drilling activity. (See Chart 19.) Moreover, OPEC and its allies have agreed to large output cuts, and compliance with the deal has so far been encouraging. So, energy prices to likely to start pushing inflation rates up from the second half of this year. (See Chat 20.)
  • As for agriculturals, we expect little movement in prices – and therefore little effect on inflation – in the next year or two. (See Chart 21.)

Chart 18: OECD Oil Stocks (Mn. Barrels)

Chart 19: US Drilling Rigs & WTI Oil Price

Chart 20: Brent Oil Price & Contribution of Energy Prices to OECD CPI Inflation

Chart 21: GSCI Agriculturals & CE Forecast

Sources: Refinitiv, CEIC, OPEC, OECD, Capital Economics

Monetary Conditions and Policy

Monetary stimulus won’t stoke inflation in the near term

  • On the face of it, the huge monetary and fiscal stimulus applied over recent months poses a significant inflation threat. Central banks have accumulated assets at a far faster pace than during the financial crisis. (See Chart 22.) This has helped financial conditions to loosen after a brief liquidity crunch at the outset of crisis.
  • Corporate bond issuance has risen sharply, particularly in major advanced economies. Meanwhile, a combination of generous central bank lending to commercial banks and government schemes to guarantee or even forgive loans has promoted a surge in lending to businesses. (See Chart 23.) This has been sharpest in the US, thanks to the Paycheck Protection Program. All of this has caused broad money growth to rise. (See Chart 24.)
  • But we think the risk that this will cause inflation to surge is relatively low, at least over our two-year forecast horizon. Businesses have taken out loans to fill a shortfall in revenues, allowing them to meet their costs rather than to finance additional spending. Meanwhile, households’ borrowing has slowed sharply (see Chart 25) and their deposits have surged as lockdowns have prevented a lot of spending. Accordingly, the “velocity of money”, which is essentially its impact on GDP, has slumped.
  • Households might spend some of their savings once lockdowns are over, but they are likely to maintain a fairly cautious stance given the fragility of labour markets. Firms may well seek to repay loans as revenues return. Meanwhile, central bank support appears to be reaching a peak. Asset purchases have already slowed sharply from the record pace of mid-March and some central bankers have talked about how to reverse the stimulus once the crisis is over.

Chart 22: Major Advanced Economy Central Bank Asset Purchases ($bn)

Chart 23: Bank Lending to Non-Fin. Corps. (% y/y)

Chart 24: M3 Money (% y/y)

Chart 25: Bank Lending to Households (% y/y)

Sources: Refinitiv, Capital Economics

Inflation Expectations

Inflation expected to recover, but to a lower level than before the virus

  • Long-term inflation expectations have fallen a little as concerns about the damaging demand effects of the virus have outweighed any anxiety about the inflationary impact of policy stimulus. In the short term, investors, economists, and households seem to agree that advanced economies will avoid a sustained bout of deflation following the collapse in oil prices.
  • In fact, households have seemingly ignored the drop in energy prices as survey measures of their inflation expectations have actually risen a bit lately. This probably reflects the greater visibility of the recent increases in food prices.
  • Meanwhile, the consensus forecasts of economists have fallen almost across the board in major economies. (See Chart 29.) After falling in 2020, inflation is generally expected to partly recover to 2019 levels by 2021. Japan is an exception in that inflation is expected to stay around zero, while inflation is forecast to rise this year in India and be fairly steady in calendar-year terms in Indonesia, Korea and China. (See Chart 29.) In stark contrast, we expect inflation in China to dip briefly into negative territory this year. (See the EM page.)
  • According to inflation swaps, investors also expect inflation to rise in the coming years, albeit more gradually in the euro-zone than in the US and UK. (See Chart 28.) The jump within the next twelve months almost entirely reflects the rebound in energy prices.
  • Long-dated inflation swaps fell sharply in March, no doubt partly due to the oil price drop and stress in financial markets. (See Chart 29.) But even as market illiquidity has abated and oil prices have recovered, 5y/5y swap rates have stabilised at a slightly lower level than they were in January in both the US and euro-zone. (See right-hand side of Chart 28.)

Chart 26: CPI Inflation Forecasts of Economists* (%)

Chart 27: CPI Inflation Forecasts of Economists* (%)

Chart 28: Swap-Implied Future Path of Inflation (%)

Chart 29: UST Spread & US 5Y-5Y Inflation Swap (%)

Sources: Refinitiv, Bloomberg, Capital Economics

Emerging Markets

Weak price pressures to embolden central banks

  • At 3%, our measure of aggregate EM inflation dropped to its lowest level on record in May. On the face of it, the 2%-pt decline seems to be in line with the fall seen in DMs. But stripping out China, inflation has fallen by just 1%-pt or so in the emerging world. (See Chart 30.)
  • We expect headline inflation to fall further in China this year. (See Chart 31.) With pork now in ample supply after last year’s African Swine Flu, food inflation will continue to weaken. That will offset any rise in core price pressures as activity recovers from the virus faster than in most other economies.
  • We expect food inflation to fall further in India too as last year’s supply shock to fruit and vegetables continues to unwind. Inflation should then rise in China and India in 2021 as the declines in food and energy inflation this year drop out of the annual comparison.
  • In other EMs, headline rates should edge higher in the second half of the year as the drag from fuel inflation eases. (See Chart 32.) But the increase should be modest. Severe weakness in demand is set to keep core inflation subdued. Moreover, weaker currencies are not a major threat to the inflation outlook. There has been little evidence of significant pass-through so far from the large currency falls suffered during the height of the market turmoil. And with demand set to stay weak in the coming quarters and currencies having recovered some lost ground, that is likely to remain the case.
  • All told, we expect most EMs’ inflation rates to settle close to or below central bank targets by the end of 2022. (See Chart 33.) This benign outlook will embolden central banks to loosen policy further, notably in Russia and Mexico.

Chart 30: Headline CPI Inflation (%)

Chart 31: EM CPI Inflation Breakdown (%)

Chart 32: CPI Inflation (%)

Chart 33: CPI Inflation Forecasts & Central Bank Targets (% y/y)

Sources: Refinitiv, Capital Economics


Jennifer McKeown, Head of Global Economics Service, jennifer.mckeown@capitaleconomics.com
Simon MacAdam, Senior Global Economist, simon.macadam@capitaleconomics.com
Gabriella Dickens, Assistant Economist, gabriella.dickens@capitaleconomics.com