John Kemp

LONDON (Reuters – As the global recovery in spending exceeds the ability of short-term service providers and manufacturers to boost output, the rapid expansion of inflation is spreading across a larger range of goods.

Previously characterised by policymakers as “transient”, the increase in inflation as the economy recovers from the exceptionally deep coronavirus-induced recession has proved larger and more persistent than they anticipated

Faster price increases are already becoming embedded in consumers’ and investors’ expectations, increasing the probability they will become entrenched as households and firms try to restore their lost purchasing power.

The possibility of a wage spiral will occur if households are successful in gaining wage increases.

If they don’t, then the decline in purchasing power and real incomes will impact consumer spending. In turn, this will lead to a decrease in the momentum of the expansion.

Inflation’s acceleration has been a significant headwind to the world economy. And the deeper the problem is, the less growth it will cause next year. (https://tmsnrt.rs/3FLA9oM).

ACCELERATION

In the United States, the consumer price index has increased at a compound rate of almost 3.4% per year for the last two years, well above the central bank’s informal target of a little over 2.0% per year.

If this happens, then the true purchasing power of wages will halve in 20 years. This is enough time to make a difference for many households.

The core consumer price index has risen by almost 2.9% annually over the last 2 years. That’s the fastest rate for the quarter century, even when you exclude volatile food items and energy.

Inflation has been slowing in core after a remarkable acceleration in the first quarter when businesses were able to reopen following lockdowns.

Core prices rose at an annualised rate greater than 2.7% during the three month period from June to September. That was the same as the 83rd percentile in all three-month periods starting in 1995.

Because inflation is so fast compared to the past quarter century, it feels instinctively quick.

EXPECTATIONS

Consumers are starting to take note of the recent price hikes and have updated their projections about inflation.

U.S. consumers now expect prices to rise by an average of 4.6% over the next twelve months and at an average rate of 3.0% per year for the next five years, according to the University of Michigan’s monthly consumer survey.

Consumers’ expectations for inflation over the next year are the highest since 2011 and in the 98th percentile for all months since 1995, indicating the households are preparing for a very inflationary environment.

Inflation expectations for the next five-years are the highest since 2013. They also rank in the 74th percentageile for every month since 1995. It is therefore expected that some of the recent price increases will continue to accelerate.

Professional investors and bond traders are also starting to see faster inflation. They demand higher yields as a way to compensate it. The result is a downward pressure on the equity and bond markets.

On the basis of breakeven rates between U.S. Treasury Notes and inflation-protected Securities, consumers will see an average inflation rate of just above 2.5% each year over the next ten.

Breakeven rates have now placed expected inflation at the 93rd per centile, for every month since 1997. This indicates that inflation is likely to continue.

GLOBAL PRICES

The acceleration of price increases is not confined to the United States but evident in all the world’s major economies, and throughout the supply chain from raw materials to producer prices and consumer prices.

China’s producer prices rose by over 10% in September, more than the previous year. This record-breaking increase was due to factories struggling to obtain enough raw materials and power.

The euro area saw consumer prices rise by 3.4% in September. It was the highest increase in prices since 2008. This follows a rapid increase in gasoline and electricity prices, which will drive inflation higher for the next few months.

The World Bank’s monthly survey of commodity prices shows energy prices have increased at an compound annual rate of 20% over the last two years while food prices have increased 19% per year.

If the world’s major central banks wanted to boost actual and expected rates from the low levels preceding the pandemic they have already succeeded, with inflation blasting through their previous predictions.

Now, the question is whether or not the current upsurge in inflation will end as incomes and wages fall behind. This would deprive the inflationary process the fuel it needs.

Or whether central bankers will need to withhold stimulus money and use the brakes on inflation to rein in forces of growth they contributed to.

MID-CYCLE LOWDOWN

As the U.S. economy loses some momentum, the most probable outcome will be an early recovery stall or mid-cycle slowdown in 2022 and 2023.

The state of the business cycle is often described in binary terms as “expansion” or “recession” but that is a simplification.

The reality is that the growth rate can fluctuate with periods of acceleration or deceleration and the only downturns being called recessions.

In the United States, the Institute for Supply Management’s purchasing managers index for manufacturing shows at least 11 significant slowdowns in growth since 1980, an average of one every 3-4 years.

The National Bureau of Economic Research Business Cycle Dating Committee only declared six official recessions during that same time frame, an average of one every 6 to 7 years.

The majority of expansions, the phase between official recessions, contained at most one early-recovery growth slowdown and/or another mid-cycle slowdown.

Although the economy was in a recession, there were no signs of a slowdown or an early-cycle stall.

Both the last two business cycle expansions saw early stalls, in 2002/2003 and 2012/2013 respectively, which were often described at the time by policymakers as a “soft spot” or “pause”.

Also, in 2015/16 there was a deceleration that occurred later, and this can be characterized as either a late-cycle slowdown or a near recession.

The anti-incumbency populist surge that swept Donald Trump into the White House likely stemmed from dissatisfaction about the economy, which was probably a result of the near-recession in 2015/16.

Officials at the central bank are keen to prevent a repetition of past early-recovery stalls. This is why they tried to maintain low interest rates and bond buying programs for longer periods.

Before attempting to reduce stimulus, the goal is to enlarge and sustain recovery. But, the rise in inflation is a serious problem.

Current business expansion has entered its 18th month. This suggests that there is a significant risk of losing momentum over the next 12-24months. The likely triggers are the increase in inflation or withdrawal of stimulus.

Other columns:

Reuters July 14, 2009: Faster U.S. Inflation erases years undershot targets

Reuters May 18, 2012: Fed’s focus on Jobs implies significant inflation overshoot

Reuters April 30, 2018: Inflation-tolerant Fed to boost commodity prices

Reuters, March 2, 2012 – A global manufacturing boom accelerates good inflation