By John Kemp
LONDON (Reuters) – Global inflation is spreading to a wider range of goods and services, as the rapid recovery in spending overwhelms the short-term ability of manufacturers, freight firms and service providers to increase output.
Previously characterised by policymakers as “transient”, the increase in inflation as the economy recovers from the exceptionally deep coronavirus-induced recession has proved larger and more persistent than they anticipated
Faster price increases are already becoming embedded in consumers’ and investors’ expectations, increasing the probability they will become entrenched as households and firms try to restore their lost purchasing power.
If households succeed in pushing for wage increases, it will create the conditions for a wage-price spiral, increasing the probability that fiscal and monetary policy will have to be tightened more aggressively.
If they do not, the erosion of real incomes and purchasing power will weigh on consumer spending, which in turn increases the probability the expansion will lose some of its existing momentum.
Either way, the acceleration of inflation has become the major headwind for the global economy, and the more entrenched the process becomes the bigger the negative impact on growth next year. (https://tmsnrt.rs/3FLA9oM).
ACCELERATION
In the United States, the consumer price index has increased at a compound rate of almost 3.4% per year for the last two years, well above the central bank’s informal target of a little over 2.0% per year.
At this rate, the real purchasing power of wages would halve every 20 years, fast enough to be noticeable for most households.
Even excluding volatile food and energy items, core consumer prices have risen at a compound annual rate of almost 2.9% over the last two years, the fastest increase for a quarter of a century.
Core inflation has moderated a little in recent months, after an exceptional acceleration in the second quarter as businesses re-opened following lockdowns.
But core prices were still rising at an annualised rate of more than 2.7% in the three months from June to September, which was in the 83rd percentile for all three-month periods since 1995.
Inflation instinctively feels fast because it is relatively rapid compared with the experience of the last quarter of a century.
EXPECTATIONS
Consumers have started to notice and update their expectations about future inflation based on their recent experience of price rises.
U.S. consumers now expect prices to rise by an average of 4.6% over the next twelve months and at an average rate of 3.0% per year for the next five years, according to the University of Michigan’s monthly consumer survey.
Consumers’ expectations for inflation over the next year are the highest since 2011 and in the 98th percentile for all months since 1995, indicating the households are preparing for a very inflationary environment.
Expected inflation over the next five years is the highest since 2013 and in 74th percentile for all months since 1995, implying a significant part of the recent acceleration in price rises is expected to prove durable.
Professional investors and bond traders have also started to notice faster inflation and demand higher yields to offset it, exerting downward pressure on bond and equity prices.
Consumer price inflation is expected to average just over 2.5% per year for the next ten years, based on breakeven rates between conventional U.S. Treasury notes and inflation-protected securities.
Expected inflation as implied by breakeven rates is now in the 93rd percentile for all months since the start of 1997, again implying that a relatively inflationary environment is thought likely to stay.
GLOBAL PRICES
The acceleration of price increases is not confined to the United States but evident in all the world’s major economies, and throughout the supply chain from raw materials to producer prices and consumer prices.
In China, producer prices were up by more than 10% in September compared with the same month a year earlier, a record increase, as factories struggled to secure sufficient raw materials and electricity.
In the euro zone, consumer prices were up by 3.4% in September compared with a year earlier, the fastest rise since 2008, with recent increases in gas and electricity prices set to push inflation even higher in the months ahead.
The World Bank’s monthly survey of commodity prices shows energy prices have increased at an compound annual rate of 20% over the last two years while food prices have increased 19% per year.
If the world’s major central banks wanted to boost actual and expected rates from the low levels preceding the pandemic they have already succeeded, with inflation blasting through their previous predictions.
The question now is whether the upsurge will burn itself out as wages and incomes fail to keep up, depriving the inflationary process of necessary fuel.
Or whether central banks will have to withdraw some stimulus and tap the brakes to bring inflationary forces they helped unleash back under control.
MID-CYCLE SLOWDOWN?
The most likely outcome is an early-recovery stall or a mid-cycle slowdown during the course of 2022 or early 2023 as the U.S. and global economies lose some of their momentum.
The state of the business cycle is often described in binary terms as “expansion” or “recession” but that is a simplification.
In reality the rate of growth is highly variable, with alternating periods of acceleration and deceleration, and only the deepest downturns described as recessions.
In the United States, the Institute for Supply Management’s purchasing managers index for manufacturing shows at least 11 significant slowdowns in growth since 1980, an average of one every 3-4 years.
Over the same period, however, the National Bureau of Economic Research Business Cycle Dating Committee declared only six official recessions, an average of one every 6-7 years.
Most expansions (the phase of the business cycle between official recessions) contained at least one early-recovery growth stall and/or a mid-cycle slowdown later in the expansion.
Early-stalls or mid-cycle slowdowns resulted in marked loss of momentum but not enough to tip the economy into a full-blown recession.
Both the last two business cycle expansions saw early stalls, in 2002/2003 and 2012/2013 respectively, which were often described at the time by policymakers as a “soft spot” or “pause”.
The most recent business cycle also saw a later deceleration in 2015/16, which could be characterised as a mid-cycle slowdown, a near-recession or even an undeclared recession.
Dissatisfaction with the economy stemming from that near-recession of 2015/16 likely explains the anti-incumbency populist wave which swept Donald Trump to the White House.
Central bank officials are anxious to avoid a repeat of previous early-recovery stalls, which explains why they have tried to keep interest rates ultra-low and maintain bond buying programmes for longer.
The aim is to entrench the recovery as much as possible and maximise underlying momentum before starting to withdraw stimulus. The rise in inflation, however, is a significant complication.
The current business expansion is now in its 18th month, which suggests the risk of a loss of momentum in the next 12-24 months is significant, with the rise in inflation and withdrawal of stimulus as likely triggers.
Related columns:
– Faster U.S. inflation erases years of undershot targets (Reuters, July 14)
– Fed focus on jobs implies significant inflation overshoot (Reuters, May 18)
– Inflation-tolerant Fed will boost commodity prices (Reuters, April 30)
– Global manufacturing surge accelerates goods inflation (Reuters, March 2)
(Editing by Kirsten Donovan)
