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January 14, 2022

News in Charts: Rising inflation risks

by Fathom Consulting.

Headline consumer price inflation has continued to soar in the major economies, reaching 7% in the US, 5% in the euro area and 5.1% in the UK on the latest numbers. The US reading was the highest since June 1982, while the euro area’s was the highest since the beginning of the single currency in 1999.

The source of the initial shock to inflation was a substantial increase in the demand for goods, which resulted in a dramatic increase in the share of goods in total consumption, since the consumption of services fell. The increasing share of goods consumption reversed a trend that had been in place for decades (chart below). Producers were not able to respond quickly enough to the rising demand for goods, putting pressure on global supply chains. There are signs that the goods share is returning to more normal levels in some countries, notably France, but in the US it remains elevated.

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A return to a more normal mix of household spending should lessen some of the upward pressure on inflation. There are already signs that shipping costs, for example, have peaked and have started to fall. Business surveys suggest prices have come off their highs in manufacturing, but pressures remain elevated.

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Ultimately, whether the impact of the initial shock to inflation proves to be transitory or sustained will depend on the expectations of firms and workers. In a recent discussion paper, Jeremy Rudd, an economist at the Board of Governors of the US Federal Reserve, suggests that the role of inflation expectations in determining current inflation is overdone. He argues that most theoretical models used to justify such a link make unrealistic assumptions,[1]  and suggests that the post-1995 dynamics of low inflation could reflect a situation where the cost of living is not on workers ‘radar screens’ and is not a major driver of their decisions to switch jobs. As a result, inflation is not a major factor in wage determination and current inflation does not respond much to past changes in inflation.[2]

We have some sympathy with this view. When inflation is seen as under control, workers may accept small fluctuations in actual inflation around the target without it affecting their desired remuneration because they believe, likely or not, inflation will be back at target next year. Some years workers win, and some years they lose. In this world, it is as if inflation expectations do not matter. However, given current rates of inflation there is a risk that we are not in that world anymore. Evidence from the University of Michigan survey suggests that US households are willing to tolerate inflation in the range 0%-3% without it affecting their beliefs about future inflation. Beyond that range, which is where we are now, inflation expectations rise broadly in line with actual inflation.

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In Fathom’s two risk scenarios, which have a combined weight of 50%, inflation expectations slip their anchor in many of the major economies. In this world, the modest increases in policy rates of interest priced in by investors will not be sufficient to bring inflation back to target, leaving policymakers facing a tough choice. They either ‘deal with it’, and bring inflation rapidly back to the 2% target, or they ‘roll with it’, and permit a sustained overshoot.

If inflation expectations have slipped their anchor, and policymakers need to do the heavy lifting, it may require a material increase in the policy rate of interest, of several hundred basis points, to bring inflation back to the 2% target. Such a tightening would trigger significant falls in the prices of interest-sensitive assets, including equities and property, both commercial and residential, threatening recession. Consequently, our judgement remains that, were the pickup in inflation to become sustained, those difficult measures will not be taken: policymakers will roll with it.

[1] In some cases, his criticisms appear valid to us, but in other cases less so.

[2] The author notes that outside of a few industries formal wage bargaining does not exist in the US. In a world where most employment is “at will”, changes in the cost of living will enter nominal wages as part of an employer’s attempt to retain workers (if firms pay workers a wage too far below the cost of living, workers will leave and firms will have to pay higher wages to retain staff and entice new recruits).

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