Factored in – but how high and for how long?

  • Markets have woken up to the inflation risk
  • Central bankers, however, display less concern
  • But markets may still underestimate the extent of coming inflation 

Bond yields have begun to rise and equity markets have fallen, both developments apparently because market actors have woken up to the risk of higher inflation. In addition, business and consumer surveys are increasingly showing signs of higher prices paid (e.g., the US ISM manufacturing survey, where the prices paid index rose to a ten-year high of 82.1 in January) or higher prices expected (e.g., the European Commission’s monthly business survey, where selling-price expectations in manufacturing rose to a two-year high of +10 in the same month).

But if markets are getting somewhat nervous, central bankers are keeping their cool. “Jerome Powell is unbothered” is the headline from Axios markets after the Fed Chair’s speech and testimony last week; while Philip Lane, member of the ECB Executive, welcomes signs of higher inflation (interview with Expansión, 22nd February). 

Of course, part of a central banker’s job description is to avoid fuelling panic. Markets, on the other hand, are notoriously susceptible to exaggerated swings in attitude, whether with regards to inflation or in other matters. Moreover, as Dr Lane notes, central banks would currently welcome inflation moving back up towards (and possibly slightly above) targets that they have failed to reach for years. However, what is not clear is whether either skittish markets or (at least outwardly) complacent central bankers have actually factored in how high inflation may go, or how long it may persist. 

Obviously, much can happen that will throw any forecast off course. But a few points highlight the possible risks. First, after slowing down for much of the second half of 2020, broad money growth has begun to accelerate again in most major economies. True, the Chinese jump in January may be due to the Lunar New Year and Japanese broad money growth is stable, if at (by Japanese standards) high rates. But on a three-month annualised basis, broad money growth is back in double digits in the US, the Euro Area and the UK. It is also picking up in smaller economies. As pointed out in a previous comment, unless the demand to hold money balances is unlimited, excess money ultimately has to go somewhere and inflate something, be it assets or goods & services prices.   

In addition, as 2021 progresses, low inflation numbers from 2020 will drop out of the comparison, pushing up 12-month rates. In fact, merely assuming that latest monthly trends remain throughout the year, gives interesting numbers. Replicating the latest monthly increases in the American core PCE deflator would mean a year-end underlying inflation rate of 3.6%. For the euro area, a slightly more conservative approach (because core inflation jumped sharply in January) still gives an underlying inflation rate of just under 4.5% by December. And, of course, this assumes that economic activity and the bottlenecks this would eventually lead to, does not accelerate during the year. Assuming the major advanced economies finally manage to subdue the pandemic during the year, that is a highly unrealistic forecast. So merely on this basis, the examples in this paragraph are likely to be on the low side.

As for how long higher inflation will persist, this clearly depends very much on policy. However, here too, there are some reasons to believe that it will last longer than many seem to expect. For inflation to fall back, either money supply has to be drained sharply, or activity has to weaken, or a combination of both. But either usually requires much higher interest rates and a perception that these interest rates will remain high for some time (e.g., spurring repayment of loans, rather than consumption). But both the Fed and the ECB are still engaged in quantitative easing, thus putting downward pressure on long-term interest rates, or at least slowing their upward march. As for policy interest rates, it will take some time to bring those to neutral, let alone to tight – and that would assume that central bankers actually are prepared to do this. Given that the Fed has already made clear its acceptance of above-target inflation, and the ECB has hinted at a similar stance, that is also unlikely. 

Moreover, central banks have a problem which will become increasingly obvious in the medium term. They are still committed to inflation targets, and even with average inflation targeting allowing some overshoot, they will not be keen to see inflation rise substantially above target. 2.5% inflation with a 2% target may be acceptable. 4.5% almost certainly is not. But on the other hand, they are facing pressure from governments that have borrowed very large sums in order to deal with the pandemic and who definitely do not want to see interest rates rise in time for debt roll-over. In addition to pressure to keep policy rates low, central banks are therefore also likely to face pressure to keep the entire yield curve subdued, i.e., the return of financial repression, or yield curve control as it is known nowadays.

The issue of rollover risks brings me to a question I have asked before: Why did governments not issue consols to finance their pandemic spending? Since these are non-redeemable, except at the issuer’s discretion, current, ultra-low interest rates would be locked in forever; and they would also spread the cost of fighting COVID-19 over future generations.

But that is a separate discussion. What we can say here, is that unless there is a marked change in central bank behaviour, or the exit from the pandemic is derailed, the likelihood is that inflation at the end of 2021 and into 2022 will not only be higher than currently expected, but also last for longer. 

Gabriel Stein