News in Charts: The inflation dilemma facing policymakers

It is now many months since we last discussed with our clients economic scenarios where COVID variants wreak economic damage on the scale that we witnessed last year. It is something we cannot entirely rule out, but in our judgment, such a low probability event is not worth considering in detail. It is, of course, the highly effective vaccines that prompted our reassessment of the risks. ONS survey data suggest that, by the end of June, around 90% of the UK population had antibodies to COVID-19, thanks largely to a successful vaccination programme, but also in part to natural infection. The impact that this has had on morbidity and mortality is striking. With the highly transmissible Delta variant dominant, the UK is currently recording close to 40,000 infections a day, not far from the peak of around 60,000 seen at the turn of the year. Nevertheless, the case fatality ratio looks to have fallen by more than 90%, from around 2.5% to 0.2%.

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Within the next month or two most major economies are likely to have offered their adult population at least a first dose, which by itself appears highly effective in preventing severe illness if not infection from the Delta variant. Several major economies that were able to keep the virus at bay last year, including Australia, New Zealand and South Korea, have been slow to purchase and deliver vaccines to their population. These countries remain at risk from both the Delta and future variants, as do many emerging economies.

Where do we go from here? Fathom expects to see a period of very strong economic growth through this year, as a portion of the pandemic savings — worth close to 10% of GDP in several major economies — is spent. Survey evidence from the US and UK central banks suggests around a quarter of excess savings will be spent. In our judgment this will, in turn, produce a sustained period of above-target inflation. The flipside of high pandemic savings in the major economies is rapid growth in the broad money aggregates. The chart below shows that, after adjusting for inflation, US real broad money balances increased by more than 20% last year. Over the past 150 years real broad money growth has been more rapid on just one occasion, and that was in the aftermath of World War II.

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It is becoming increasingly apparent that the pick-up taking place in inflation, particularly in the US, is cyclical, and not just a consequence of base effects. Traditionally, any cyclical pick-up in inflation has required a monetary policy response — and yet that is not the intention of policymakers at present. The FOMC continues to believe that the pick-up will be transitory. At Fathom, we have our doubts. Inflation overshoots driven by circumstances such as a spike in the oil price or a change in tax rates tend ultimately to subtract from household real incomes. In that sense, they can be self-limiting, and deflationary in the long run, and it is often appropriate for policymakers to look through them. But that is not what we are seeing here. Only in the unlikely event that higher product prices do not feed through at all to higher wages, which would require a very strong degree of faith in policymakers’ ability to rapidly bring inflation back to target, would a cyclical pick-up in inflation be self-limiting.

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If we are right, and households try to make up for lost time in their spending rather than smooth their pandemic savings over the remainder of their lifetimes, causing a material, cyclical increase in inflation that does not go away of its own accord, how will policymakers respond? They are likely to be faced with a choice of either ‘dealing with it’, and tightening policy sooner than many imagine, triggering a recession; or ‘rolling with it’, and moving to a higher inflation target. We believe the latter would be a better response.

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