Inflation is back

Even the core rate of inflation, not including energy and food, was four per cent, a level not reached since 1991. This jump in inflation is due to a combination of strong demand and a shortage of supply for many goods.

Co-founder and CIO at Flossbach von Storch

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In the USA, consumer prices have risen by at least five per cent year-on-year for four months in a row. Even the core rate of inflation, not including energy and food, was four per cent, a level not reached since 1991. This jump in inflation is due to a combination of strong demand and a shortage of supply for many goods due to the pandemic and a significant increase in energy and electricity prices. In the USA in particular, generous government aid programmes put a great deal of money into the pockets of consumers.

This Coronavirus boost can also be seen in the sharp increase in the money supply. The M2 money supply (cash + nonbank deposits with credit institutions + money market funds for private investors) has risen 34 per cent since February 2020, corresponding to an annual growth rate of 22 per cent (see Figure 1). After initially being saved as a precaution, the funds were increasingly being used for consumption (cars, electronics, clothing, travel, etc.).

Inflation naturally calls the central banks, which are required to maintain monetary stability, into action. It had been below central bank targets for a long time, even though they had done everything to raise it to the desired level of two per cent. Now the genie is out of the bottle and it might be difficult to get it back in. Interest-rate increases, the traditional remedy in earlier inflationary periods, are a risky proposition today. Given the high level of national debt and the still-fragile, post-pandemic upswing – particularly in the eurozone – interest-rate increases could only be justified in homeopathically small doses for the foreseeable future. That is why central banks, in particular the European Central Bank (ECB), are providing reassurances with the narrative that it is just a temporary bump in inflation that will disappear by next year as the supply bottlenecks are resolved. If inflation turns out to be persistent, however, this narrative will lose credibility.

Although US Federal Reserve (Fed) Chair Jerome Powell now thinks the current situation could continue longer than initially thought, he also expects the situation to ease again once the bottlenecks in production and logistics are resolved. He therefore does not expect the current increase in inflation to usher in a regime change, but adds that the Fed will take action if it detects a significant increase in inflation expectations.

One can see how inaccurate recent central bank inflation forecasts have been by comparing the inflation forecasts for 2021 made at the beginning of the year and the adjusted inflation expectations in September (see Figure 2).

It is, of course, particularly difficult to forecast future inflation during a pandemic. That is not holding the ECB back, however, from publishing precise inflation expectations for coming years. It is forecasting a general rate of inflation of 1.7 per cent for 2022 and 1.5 per cent for 2023. A quick look at the past shows how low its accuracy has been (see Figure 4 on the following page). The forecasts likely mainly serve to steer people’s inflation expectations in the right direction or, in central bank jargon, to anchor them.

You don’t need to be a cynic to see these values as wishful thinking. High inflation expectations would put central banks under pressure to act and could also cause bond yields to soar. Given the fragility of the upswing and the high levels of debt of some eurozone countries, this would be a particularly great burden for the eurozone.

They would therefore like to maintain their low interest-rate policy as long as possible and justify this with low inflation expectations for the next few years. It seems almost bizarre that the central bank is aiming to increase inflation to the target level of two per cent, even though inflation is already significantly higher. In theory, the ECB could continue this game forever, issuing new forecasts each year that predict good weather for following years. In practice, however, this strategy reaches its limits when people lose their trust and adjust their inflation expectations and behaviour to reality.

Whether we really are at the beginning of a new inflationary regime, i.e. a sustained period of inflation rates significantly above two per cent, depends on several factors. On the supply side, prices are being driven up for at least the short term by bottlenecks in production and logistics. Demand is determined by the propensities to consume and invest, which depend on available liquidity and expected economic growth. Psychology plays an important role.

The more that people consider the current increase in inflation as permanent, the more likely they are to buy durable goods (e.g. cars). This is all the more true if the abundant liquidity people have in their accounts generates no interest and increasingly loses value due to inflation.

On the other hand, shortage-related sales losses, job losses, short-time work, and company bankruptcies decrease the propensities to consume and invest, thereby also reducing the upward pressure on prices and economic growth. This illustrates the interactions in the economy that cannot be calculated with mathematical equations. It is, however, helpful to identify the causes of inflation in order to better understand the character of the current inflationary trend and its consequences.

The following factors are directly affecting inflation and may be temporary in nature:

  • Rising energy and electricity prices
  • Supply chains disrupted by the pandemic
  • Shortage of labour in some sectors
  • Rapid growth in the money supply (due to extensive Coronavirus aid measures) Medium- and long-term drivers of inflation:
  • Deglobalisation, i.e. renationalisation of production capacity
  • Decarbonisation or electrification of the economy
  • Demographics, i.e. increasing shortage of qualified labour due to the retirement of the Baby Boomers
  • Higher wage demands in coming collective bargaining rounds (second-round effects)

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Inflation is back