Chart of the Week: Inflation in the post-pandemic world

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The inflation outlook in the post-pandemic world is a contentious issue, gaining much media attention and is even the focus of a series of notes from Fathom Consulting. The first of three focuses on the ways in which economists have tended to think about the inflationary process, such as the output gap, and concludes that while measuring this intangible concept is fraught with difficulties, and perhaps decreasing relevance as the nature of economic production evolves (think Netflix), it will still be a valuable tool in the unique economic circumstances of the pandemic. Indeed, as we emerge from the pandemic and economies reopen in full, aggregate demand is likely to rise sufficiently far, relative to potential, to put significant upward pressure on inflation. Why?

One reason is the unprecedented nature of the response from both monetary and fiscal policymakers to the crisis. The outcome of a policy that seeks to provide households with incomes close to, if not equal to pre-pandemic levels, while simultaneously forbidding those same households from purchasing many of the goods and particularly services that they would normally purchase, is a substantial build up in savings, evident in the chart above. The path of economic activity and inflation across the major economies through this year and next will depend, to a great degree, on how rapidly those excess savings pots are spent. Having been denied the right to undertake pleasurable forms of economic activity for more than a year, Fathom believes that households will make up for lost time, spending a sizeable chunk of the accrued savings quickly, eroding the output gap and putting upward pressure on inflation. This is a view that the Bank of England has moved a little closer to, recently doubling the amount of savings that it assumes will be spent.

Whether this inflationary pressure is sustained will depend on the monetary policy response, and on the beliefs of wage- and price-setters — neither of which are easy to predict.

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