April 12, 2021

News in Charts: Will the recovery be inflationary?

by Fathom Consulting.

Households in the major economies have built up substantial excess savings pots during the past 12 months, supported by government programmes set up to limit the economic harm caused by the pandemic. We estimate that, by the end of March, these amounted to some 6%-8% of annual GDP in the US and the UK, and some 3%-4% of annual GDP in the euro area. What will happen to these savings as economies reopen? In answering this question, policymakers have taken what seems to us to be an overly cautious approach.

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In putting together its February Monetary Policy Report, the Bank of England’s Monetary Policy Committee assumed that just 5% of these excess savings pots would be spent by UK households over the next three years. However, it seems inappropriate to use textbook economic models to treat these excess savings pots, built up through enforced abstinence during a pandemic, in the same way as one might treat truly exogenous windfall gains. The dramatic increase in household savings was a rational, endogenous response to an extremely difficult set of circumstances. Rather than spend the money on other things that they were allowed to enjoy, like more goods, households chose to save – presumably in order to spend at least some of the money on the temporarily prohibited activities once the prohibition was lifted.

In Fathom’s central scenario, to which we attach a 50% weight, we assume that households in the major economies spend around 10% of their pandemic savings in the next two years, with most of it spent this year. In our upside risk scenario, to which we attach a 30% weight, this proportion rises to 50%. It goes without saying that had the Bank of England assumed anything other than a very gradual unwinding of these excess savings pots, their inflation fan chart would have looked very different, with a significant chance of inflation lying above target for most of the forecast horizon.

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Recent US data appear consistent with a very strong recovery in activity, with the US economy adding close to one million jobs in March. Were that pace to be maintained, nonfarm payrolls would return to pre-pandemic levels by the end of this year. On Monday of this week, we learned that the business activity component of the ISM non-manufacturing index reached 63.7 in March, the strongest reading since the survey began in the late 1990s. And the ‘prices paid’ component pointed to a more rapid increase in prices than at any time since the Global Financial Crisis.

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Just over a year ago, investors were treating the pandemic as primarily deflationary. Back in March 2020, the global economy suffered substantial negative shocks of roughly equal magnitude to both demand and supply. Governments around the world ordered whole industries to stop producing, and simultaneously ordered firms and households to stop buying their products. Since then, investors have gradually reversed their way of thinking. From here on, the consequences of the pandemic are likely to start pushing inflation higher, globally. Just how much higher depends, in part, on the pace at which excess savings pots are spent, and on the reaction of policymakers to a period of above-target inflation at a time when government debt levels are very high.

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