Inflation measures the rate of change of consumer prices. It is caused by overall demand exceeding supply. Thus ‘too much money chases too few goods’ pushing prices higher.
Chart 1: Fed funds rate
Source: Bank of Singapore, Bloomberg
In the 1970s, inflation reached double digits in many major economies. The US government expanded spending on social programmes and the Vietnam War while also devaluing the USD by removing its link to gold. The 1973 and 1979 oil shocks further fuelled price rises. As the chart shows, even core measures of consumer price index (CPI) inflation - excluding volatile food and energy costs - hit double digits.
But in the 1980s, Federal Reserve Chairman Paul Volcker crushed inflation through very high interest rates despite strong political opposition.
Chart 2: US inflation
Source: Bank of Singapore, Bloomberg
Since the 1990s, inflation has been subdued as independent central banks have set interest rates to keep consumer price rises limited to 2% a year. This period of stable prices has lasted for three decades across all the major economies.
In the first half of 2021, however, inflation is set to pick up again. For example, the Fed’s target measure of inflation - changes in core personal consumption expenditure (PCE) prices - is likely to exceed the central bank’s 2% goal from 1.4% year-on-year currently. At the chart above shows, PCE prices fell sharply in March and April at the start of the pandemic. But next spring, the weak readings will fall out of the year-on-year measure, lifting core PCE inflation in early 2021 towards 2.0% year-on-year.
Chart 3: Savings & unemployment, US
Source: Bank of Singapore, Bloomberg
At the same time, the provision of vaccines may also lead to a burst of inflation in 2021 as consumers are finally able to run-down savings built up during this year’s lockdowns. As Chart 3 shows, the US savings rate soared to 33% of personal incomes in April as the government distributed stimulus cheques to households. Even now, the savings rate still remains above 13%, giving consumers ample funds to spend again.
The near-term concern for investors is whether the pick-up in inflation in 2021 proves temporary - as we expect - or leads to sustained price rises in subsequent years that undermines risk assets.
The case for higher inflation beyond next year rests on several factors.
First, the unprecedented monetary stimulus enacted this year is far greater than that employed during the 2008 financial crisis. As the chart below shows the Fed’s and the European Central Bank’s balance sheets have ballooned in 2020 as central banks printed money massively to support growth through quantitative easing.
Chart 4: Fed, ECB balance sheets
Source: Bank of Singapore, Bloomberg
Moreover, commercial banks have much stronger balance sheets now compared to a decade ago. Thus, the financial sector is able to lend on the huge liquidity created by this year’s quantitative easing in loans to individuals and firms. In turn, stronger credit growth will support demand and spending and thus may start pushing consumer prices higher - in contrast to the aftermath of the 2008 financial crisis when commercial banks were unwilling to lend aggressively and focused instead on repairing their balance sheets.
Second, fiscal stimulus to support demand has also been far greater in 2020 than during the 2008 financial crisis as the next chart shows.
Chart 5: Fiscal deficits
Source: Bank of Singapore, Bloomberg
For example, the Office for Budget Responsibility (OBR) estimates the UK government’s deficit will reach GBP394 billion this year - around 20% of GDP - its worst levels since 1944 in World War II.
Furthermore, G7 governments will not reduce fiscal deficits quickly after the pandemic as politicians have little support to make widespread cuts in public spending and tax increases that were imposed through ‘austerity’ policies after the 2008 crisis. Central banks may thus be inclined to keep borrowing costs low to enable governments to continue funding their huge budget deficits, adding to the risk of higher inflation in future.
Third, inflation may also pick up more than expected as the Fed is now actively seeking to overshoot its 2% target so that inflation averages 2% over the course of the business cycle.
Chart 2 shows the central bank has been missing its 2% inflation goal for much of the last decade. Thus, in August, the Fed said it would shift to a strategy of average inflation
targeting so that it would tolerate rises in consumer prices temporarily exceeding its 2% target to make up for periods when inflation falls shorts of 2%.
The risk here is that as inflation picks up next year, the Fed will not start raising interest rates. Instead the central bank will tolerate inflation overshooting its 2% target in the near term. But if inflation expectations also increase and individuals and firms expect consumer prices to rise by more than 2% for several years then higher inflation rates exceeding the Fed’s 2% target may become entrenched. The central bank would then have to play catch up, hiking interest rates rapidly to bring inflation back under control.
Fourth, supply side pressures after the pandemic subsides may also start to push consumer prices higher over time.
Firms’ costs may increase if immigration curbs make it harder to employ workers from abroad. Governments may also encourage domestic companies to bring supply chains back home to increase domestic ‘resilience’ to future shocks. If sectors of the economy face lower competition after the pandemic - because firms have gone bankrupt - then surviving companies may be able to raise prices without losing market share.
Last, ageing societies in both advanced and emerging economies will reduce prime working-age populations relative to children, students, pensioners and other dependents. Firms may therefore have to raise wages to attract and retain scarce workers and subsequently pass on the costs to their customers through higher prices.
In the near term, investors fearful of higher inflation should hedge portfolios using gold.
But in the longer-term, the risk of higher inflation in 2021 leading to sustained price rises in subsequent years is still likely to be limited by independent central banks, unemployment and globalisation all curbing inflation in future.
Chart 6: US inflation expectations
Source: Bank of Singapore, Bloomberg
The chart above shows US inflation expectations have become anchored near the Fed’s 2% target over the last three decades. The central bank’s credibility in ensuring inflation meets its 2% goal has resulted in America’s public expecting prices to be broadly stable, rising only around 2% each year, in line with the Fed’s inflation target.
Fed officials are very aware that the central bank’s credibility has been hard won by having to pursue very high double-digit interest rates in the 1980s to curb the high inflation rates of the 1970s. Thus, monetary policymakers will not want inflation to take off much beyond their 2% target in future. The Fed is independent so it can raise interest rates fast if the central bank feels inflation may become unanchored from its 2% goal.
Similarly, since the 1990s, most major central banks have been granted independence to pursue 2% inflation targets without political interference. The European Central Bank was set up with the advent of the EUR in 1999 with an explicit target for price stability and the Banks of Japan and England became independent monetary institutions in the late 1990s. Thus, all the major central banks are likely to be wary of letting inflation rise in a sustained manner in future beyond their 2% goals and have the ability and willingness to tighten monetary policy.
Inflation is also likely to remain under control because unemployment after the pandemic will make it hard for employees to seek higher wages. The chart on page one shows America’s jobless rate has fallen from a huge 14.7% during the first wave of the pandemic in April to 6.7% in November. But it remains well above the 3.5% rate prevailing at the start of the year. Moreover, even when the US economy was running at levels consistent with full employment at the beginning of 2020, core PCE inflation was still stubbornly below the Fed’s 2% target.
The major central banks’ record of missing their 2% inflation targets over the last decade - even with very low unemployment rates - implies consumer price rises in future are unlikely to start exceeding 2% in a sustained manner. In particular, the long-term trends that have pushed inflation down over the past few decades - technology automating jobs and thus tempering wage growth, globalisation leading to more competitive manufacturing and aging populations shrinking consumer markets - are unlikely to be altered by the pandemic.
Therefore, we think the likely pick-up in inflation in 2021 may temporarily exceed central banks’ 2% targets but will not lead to sustained price rises that cause inflation to keep running above 2% for years afterwards. Instead, we expect the Fed, for example, will not need to start raising its fed funds interest rate from current levels of 0.00-0.25% until as late as 2024 or 2025 as inflation stays anchored around 2% over the next few years.Disclaimer applicable to recommendation
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Version: July 2020