Second guessing the second-round effects: Dissecting the exogenous price shock

A key variable here is the starting point for the “buoyancy” of consumption. We measure this by comparing the actual level of consumer spending to the volume it would have reached had it constantly grown in line with its 2010-2019 trend.
Gilles Möec

Chief Economist

AXA

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The steep rise in gas prices – even if recent statements from Vladimir Putin have cooled down the market somewhat – is naturally fueling concerns around a prolongation of the ongoing inflation spike, which could fan risks of “second round effects” turning what has remained so far an exogenous shock into a self-fulfilling upward shift in the inflation regime.

A key variable here is the starting point for the “buoyancy” of consumption. We measure this by comparing the actual level of consumer spending to the volume it would have reached had it constantly grown in line with its 2010-2019 trend. In the US, despite the rise in the savings ratio, the stimulus-fueled massive growth in income has brought consumption back to its trend level last spring. In the absence of any “consumption gap”, demand pressure is hitting hard sectors faced with disrupted supply, making it tempting for producers to deal with the pressure from rising input costs by lifting their final prices. 

The situation is very different in the Euro area, where the consumption gap still stood at a staggering -7% in Q2 2021. True, the catch up continued at a fast clip in Q3, even if precise data is not yet available, but it is unlikely, given the differences in income dynamics relative to the US, that the gap has been fully bridged by now. With consumption still far from having normalized, weak demand is chasing the available supply. The room for manoeuvre for passing higher input prices to consumer prices is much more limited in the Euro area than in the US. The difference in terms of consumption gaps may help explain why inflation has been quicker to accelerate in the US than in Europe. 

A crucial issue though is whether the point has been reached when the inflation spike in turn starts affecting the volume of consumption. Under a textbook approach, exogenous price shocks spontaneously fade. Indeed, they tend to be recessionary – the point was made by the ECB’s chief economist Philip Lane last week – since they immediately depress purchasing power. The economy cools down fast enough to stop an adjustment in wages. It is tempting to ascribe to the ongoing price spike in the US the lack of further acceleration in consumer spending since last spring (it has fallen back marginally below its trend level this summer). Yet, since this coincides with the peak in the “delta variant” wave over there, it is probably impossible to disentangle what would be the reaction to rising prices from self-restraint by worried individuals. The next months of consumption data, now that the US pandemic wave is finally going in the right direction, will allow for better analysis.

A source of added complexity is the fate of the excess savings accumulated since the start of the pandemic everywhere in the developed world. They constitute spending reserves which should sustain consumption despite the dampening effect of inflation on purchasing power, thus “blocking” the self-stabilization mechanism which normally stops exogenous inflation shocks from developing dangerous second-round effects. In theory, the inflation spike should accelerate the liberation of excess savings. Rationally, especially with negative interest rates, individuals would maximize their welfare by converting their savings into consumption as soon as possible before the purchasing power of those savings is eroded. This creates a risk that, with consumer spending more resilient to the inflation shock, the latter persists longer than usual.

Yet, even if the inflation shock takes longer to fade, for all the discomfort it would bring to central bankers, it would not necessarily mean that a proper upward shift in the inflation regime. For this to happen, wages need to respond to the shock.

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Second guessing the second-round effects: Dissecting the exogenous price shock