30th November 2021
First the debate was: is inflation or deflation the higher risk?
Then, when inflation arrived, the question was would inflation be transitory or not?
But even now, after months of higher than expected inflation, there remains a debate about the outlook and what, if anything, to do about it. That largely reflects another debate – whether supply constraints or strength in demand is the primary cause of the current higher inflation.
In a recent post, Bridgewater argued that the current inflation is primarily been driven by demand not supply, whereas other prominent economists like Paul Krugman argue aggregate demand is actually not that strong. He points to real final demand ex inventories in the US which is only just back to trend.
The Krugman argument masks an important point about the current inflation episode: it has been driven by a sharp change in the composition of demand (towards goods and away from services) at a time when the production of those goods has struggled to keep up.
Earlier this month the World Economic Forum released their latest survey of Chief Economists at various large international institutions. The report showed a high degree of uncertainty as to whether inflation expectations broadly in the economy would be unanchored by the recent episode of inflation and a fairly even split as to whether monetary policy is the most effective tool for dealing with the current inflation.
These economists were surveyed in October. Since then we’ve had even higher inflation readings in the US and in Europe but more recently the emergence of concerns around the Omicron variant, further compounding the sense of uncertainty.
If the Omicron proves to be more transmissible than other variants, and inflicts more serious disseise will that have a bigger impact on spending or on production and supply?
The case for a moderation of inflation
That said there remains a prominent view that although inflation may remain high for the coming months it is likely to moderate over time from here.
That view tends to rest on one or a number of the following points
The current inflation is mainly caused by the supply side: these issues will iron themselves out over time
We won’t see significant second order effects: it’s not the 1970s (there is less unionisation etc)
Longer term disinflationary trends are still in the background and disinflation and deflation is still a risk
There is actually a risk of a recession –look at consumer confidence data, the recent bouts of curve flattening reflecting the risk of central bank policy error.
When thinking about the outlook for inflation, it’s useful to appraise those arguments.
Will the supply side disruptions be ironed out over time?
The interesting feature of the current supply challenges is that they are so varied from the lower level of labour force participation to higher energy prices.
I’ve set the main ones out below and my thoughts on how quickly they are likely to normalise.
So on the goods production and distribution side it seems reasonable to expect normalisation over time. The BIS suggest the supply side challenges have been accentuated by the “bullwhip effect” (downstream overordering to build buffers causing even bigger impacts on upstream production) so we may see falling prices once this unwinds although the timing is hard to assess. However, its is possible that labour force participation won’t recover and NAIRU may be higher than thought.
Will we see second order effects?
Regardless of what you believe about inflation expectations, real wages have fallen so there is likely to be a catch up effect where people negotiate higher wages to restore their real incomes
Yes, a return to the 1970s is not yet on the cards. Why?
US dollar weakness was a big part of the US inflation surge in the 1970s; this time the USD rally should be a headwind for US import prices.
In the 1970s the US had just exited the Bretton woods system, the link with gold had just been broken and there were price adjustment once price caps were removed; we don't have a similar scenario now.
From the perspective of second round effects consumer behaviour will be key to monitor. It’s not just about wage negotiations: if consumers start to accelerate purchases in anticipation of prices rises or increase borrowing on the belief that inflation will erode the real value of debt that could accelerate inflation.
Disinflationary forces
Debt levels are even higher than pre-COVID adding weight to the argument that high debt levels will be a disinflationary force (higher debt levels causes people to use some of their resources for servicing debt rather than spending).
However, high debt provides an incentive for financial repression from central banks to allow inflation to erode the real value of debt.
The composition of mortgages has changed in the US and UK towards a higher % of fixed rate so you may get a nonlinear reaction to higher rates (not much initially then a lot more over time as fixed rates adjust)
Demographic trends may not be as disinflationary going forward (Goodhart and Pradan arguments).
And on the other side of the equation, the greening of the global economy may be a multi-year reflationary force
The outlook for demand.
Although nominal GDP in the US is growing at about 10% per annuum there remain some people who see a risk of a recession.
Yes, there are risks to the global economic outlook, particularly weakness in Chinese growth but three factors suggest recession risks are overblown.
Financial conditions are very accommodative
Surging asset prices (both stocks and housing) have created a massive positive wealth effect
The labour market is tight and workers are able to negotiate wages increases.
Bottom line
It is likely that certain goods prices will mean revert as supply issues resolve but some supply challenges such as the labour market may remain.
There are tailwinds for demand from wealth effects, accumulated savings, rising incomes, capex rising in response to supply chain issues, postponed production and the greening of the economy.
In summary, supply issues are likely to resolve somewhat but the demand outlook in developed markets continues to look strong so my expectation is that inflation will stay above trend for a number of years.
The big issue for markets isn’t so much a return to the 1970s it’s the challenge for central banks removing policy accommodation without precipitating a major financial market event.