Inflation, defined as a general rise in the price level across the economy and the associated fall in the purchasing power of money, is a hot topic in financial markets at the moment. There is concern amongst some investors that, following unprecedented stimulus from both governments and central banks during the pandemic, we could be about to experience an inflationary episode akin to that of the 1970s, when annual price increases in the US and the UK averaged around 7% and 12% respectively1,2. What are the chances of this happening?
In assessing the prospects for inflation, it is important to differentiate between a short-term, transitory rise in prices and a longer-term, sustained period of elevated inflation over a period of several years.
Base effects
Headline inflation rates in the US and other major economies have risen recently and are likely to continue rising during the coming months3. Part of this is due to something that economists call ‘base effects’: the natural tendency for annual growth rates to jump as this year’s prices are compared with last year’s abnormally weak, pandemic-stricken readings. This effect is most pronounced regarding energy and fuel - the average price of a barrel of Brent crude in March 2021 was around US$65, more than double the US$32 prevailing a year earlier4 – but will also be apparent in other areas, for example hospitality and leisure.
Recent disruption to supply chains and logistical delays resulting from the pandemic, as well as adverse weather and other factors, are also putting upward pressure on company costs. Supply and demand imbalances in recent months have boosted costs for a wide range of goods including computer chips, shipping containers, timber, copper and other commodities5. Indeed, according to the latest Markit global PMI survey, companies are facing the steepest rise in input prices since August 2008 6.
Pent-up demand
Given that the pandemic has resulted in a large amount of pent-up demand and excess savings in much of the developed world7, there is a good chance that businesses will be able to pass some of these cost increases on to the consumer. In sectors where capacity has been reduced by the pandemic – for example by companies going out of businesses – and competitive pressures have been reduced, corporate pricing power will have risen. Some businesses will also take advantage of strong ‘reopening’ demand to raise prices and make up for revenues lost during the pandemic. Anyone trying to rent summer holiday accommodation in the UK will be familiar with this dynamic.
However, much of these influences on inflation should prove transitory. Central bankers in developed economies are well aware of these dynamics, and with unemployment still well above pre-pandemic levels, they are in no mood to pursue pre-emptive monetary tightening to counter such trends. Indeed, in the US, one of the reasons to expect a period of modest above target inflation is because, under the flexible average inflation targeting policy of the Federal Reserve (the US central bank), the monetary authorities are actively seeking higher inflation to compensate for an earlier period when inflation has consistently come in below their 2% target (see our commentary of September 2020).
And yet, for a modest, temporary inflation overshoot to morph into a sustained period of elevated inflation would require a reversal of the structural changes (including globalisation, automation, central bank independence, etc.) that have facilitated low inflation in recent decades.
Wage-price spiral?
A key element in this regard is the bargaining power of workers. One factor behind the sustained high inflation of the 1970s was the strong bargaining position of labour afforded by high levels of unionisation. This enabled a wage-price spiral to develop. However, in recent decades, the ability of workers to negotiate large pay increases has been undermined by a range of factors including lower levels of unionisation, labour market deregulation, globalisation and automation. These developments have contributed to a weakening in the relationship between levels of unemployment and wage growth (i.e., the tendency for pay growth to accelerate when workers are in short supply - a phenomenon economists call ‘the Phillips Curve’).
Against this backdrop, an increase in the price level resulting from a one-off rise in costs (say from a spike in the oil price) is now more likely to result in a decline in real (i.e., inflation-adjusted) wages rather than set off a cycle of increased labour costs leading to spiralling consumer prices. This is essentially what happened in the UK following the sharp fall in the pound and related rise in import prices following the 2016 EU referendum8.
The question going forward is whether this dynamic is likely to change in a meaningful way. In the US, President Joe Biden is encouraging workers to join unions as a means to secure better pay deals. However, the recent experience in Alabama, where Amazon warehouse workers voted against union membership9, suggests Biden’s campaign is yet to gain traction.
Increased government spending might prove to be a vehicle for change; Biden’s recently proposed US$2 trillion infrastructure programme (the so-called “American Jobs Plan”) promises millions of “good-paying, union jobs”10. However, companies are likely to resist a move towards increased unionisation, and with the Democrats commanding only the slimmest of majorities in the Senate, it remains to be seen how much of Biden’s plan will actually come in to force.
In the UK, the prospects for a government-initiated spurt in pay growth look slim. Chancellor Rishi Sunak has already outlined plans to rein in the budget deficit, and the pay-freeze for most public sector workers is ongoing11. Such restraint should serve to anchor wage growth in the private sector.
Some observers see demographic trends as a potential driver of future inflation. Charles Goodhart and Manoj Pradhan argue that ageing populations in the developed world and China will create a shortage of workers which will drive up wages and lead to faster inflation12. While it is possible that immigration from the developing world could provide a ready source of labour, political considerations might be a barrier to such flows.
Central bank paradigm shift?
However, even if workers do see an improvement in their bargaining power in the future, a move towards a period of 1970s-style inflation would also require a paradigm shift regarding central banks’ reaction function, independence and credibility. Sure enough, in the US, the Fed’s move to an average inflation target has seen policy makers move away from a mindset of pre-emptive monetary tightening to one of only hiking rates when inflation “moves moderately above 2% for some time”13. However, while the Fed has not formally quantified what “moderately above 2%” might be, Robert Kaplan, President of the Dallas Federal Reserve Bank, has said it probably means 2.25-2.5%14. Assuming Kaplan’s thinking is broadly in line with other Fed officials, this suggests the US central bank will start tightening policy well before inflation takes off.
There is clearly a risk that governments will put pressure on central banks to keep policy looser for longer in a bid to restrain debt servicing costs. This is a pertinent consideration in the UK, where debt servicing costs have become more sensitive to the Bank of England’s policy interest rate15. Nevertheless, this would be a hazardous path for governments to go down and would risk provoking an adverse reaction in financial markets.
As it stands, there is little indication that either households or financial markets are losing faith in developed world central banks’ ability to keep a lid on inflation. Longer-term inflation expectations derived from both household surveys and financial market indicators have picked up recently, but are within recent historic ranges and broadly consistent with central bank inflation targets around the 2% mark 16,17,18.
Upside risks, but no 1970s redux
This said, there is no room for complacency and a range of indicators will need to be monitored for signs that underlying price pressures are picking up. In the near-term, this task will be made more difficult by distortions to the data arising from the pandemic. Given that US policymakers are keen to run the economy ‘hot’, inflation risks certainly appear skewed to the upside. It would not be surprising to see underlying inflation during the next few years come in somewhat higher than we have been used to. However, while there might be some dialling back of the structural factors that have borne down on inflation in recent decades, we are not about to turn the clock back half a century. Although flared trousers have made something of a comeback in recent years, the chances are that 1970s-style inflation won’t.
19th April 2021
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https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/czbh/mm23
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https://www.ft.com/content/37990b3a-0c26-459e-9046-98fc2c7d24cf
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https://www.theguardian.com/business/2021/mar/21/global-shortage-in-computer-chips-reaches-crisis-point
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https://ihsmarkit.com/research-analysis/global-price-gauge-hits-new-high-as-input-cost-inflation-accelerates-sharply-Apr21.html
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https://www.ft.com/content/8cbfe40d-1ce1-4dc6-bcb2-1314b77b9443
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https://www.ft.com/content/cf51e840-7147-11e7-93ff-99f383b09ff9
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https://inews.co.uk/news/politics/spending-review-2020-rishi-sunak-partial-pay-freeze-workers-public-sector-771628
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https://blogs.lse.ac.uk/businessreview/2020/09/18/the-great-demographic-reversal-and-what-it-means-for-the-economy/
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https://www.cnbc.com/2021/04/11/powell-says-its-highly-unlikely-the-fed-will-raise-rates-this-year-despite-stronger-economy.html
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https://www.fxstreet.com/news/feds-kaplan-moderate-overshoot-on-inflation-probably-means-225-or-25-202008271726
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https://www.ft.com/content/0e48c8ab-e3b4-404f-8776-d9a42df27ce1
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https://www.bankofengland.co.uk/inflation-attitudes-survey/2021/february-2021