COVID | Global | Monetary Policy & Inflation
• Global inflation fell sharply in the early months of the Covid-19 crisis, mainly because of oil
• Core inflation fell most significantly in the US but has now begun to snap back
• I expect DM inflation to be higher over the next decade than in the last
• The key drivers of this will be less global integration and central bank policy
One of the most interesting (and important) debates underway is the inflation outlook for the post-Covid-19 (C-19) world. In the near term, the C-19 crisis has worked to lower headline inflation rates across the global economy. In the G7 economies, the inflation rate fell from 2%oya in January to 0.2%oya in May. In my EM sample, the rate fell from 4%oya in February to 2.1%oya in May (Chart 1). Rates across the world ticked back up in June and (based on early-reporting countries) rebounded even more in July.
As the near-term deflationary shock from the immediate C-19 slump fades, the key issue is what comes next. As C-19 unfolded, there was widespread agreement among both the analyst community and market participants that the crisis would be a profoundly deflationary event. Market pricing of forward inflation (as reflected in inflation swaps, for example) slumped to a low in mid-March (Chart 2). Since then, however, they have rebounded to about the same (depressed) level that they reached in 2019H2; the uptick since mid-May has been particularly pronounced.
This readjustment up in medium-term inflation expectations is appropriate and probably has further to run. In my view, the longer-run scars left on the global economy by the C-19 crisis could tilt inflation upwards in the decade ahead for two reasons.
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• Global inflation fell sharply in the early months of the Covid-19 crisis, mainly because of oil
• Core inflation fell most significantly in the US but has now begun to snap back
• I expect DM inflation to be higher over the next decade than in the last
• The key drivers of this will be less global integration and central bank policy
One of the most interesting (and important) debates underway is the inflation outlook for the post-Covid-19 (C-19) world. In the near term, the C-19 crisis has worked to lower headline inflation rates across the global economy. In the G7 economies, the inflation rate fell from 2%oya in January to 0.2%oya in May. In my EM sample, the rate fell from 4%oya in February to 2.1%oya in May (Chart 1). Rates across the world ticked back up in June and (based on early-reporting countries) rebounded even more in July.
As the near-term deflationary shock from the immediate C-19 slump fades, the key issue is what comes next. As C-19 unfolded, there was widespread agreement among both the analyst community and market participants that the crisis would be a profoundly deflationary event. Market pricing of forward inflation (as reflected in inflation swaps, for example) slumped to a low in mid-March (Chart 2). Since then, however, they have rebounded to about the same (depressed) level that they reached in 2019H2; the uptick since mid-May has been particularly pronounced.
This readjustment up in medium-term inflation expectations is appropriate and probably has further to run. In my view, the longer-run scars left on the global economy by the C-19 crisis could tilt inflation upwards in the decade ahead for two reasons.
First, and most importantly, the virus may well have damaged the economy’s supply capacity more durably than demand. Many companies will struggle to survive, likely lowering competitive pressures within economies. Moreover, the virus will probably accelerate a trend away from global integration that was already clearly evident pre-crisis. In my view, the sourcing of cheap external goods and, increasingly, services had been an important factor in lowering inflation pressures over the past 20 years. China’s decision to focus inwards in its next five-year plan, from 2021 onwards, is very important in this context.
Second, macroeconomic policy has become very expansionary and is likely to remain so. At some point during H2 (most likely September), the Federal Reserve is likely to commit to accepting and welcoming a sustained overshoot in inflation above 2% in 2021 and beyond. Whether or not this is a credible commitment is an issue. It raises the likelihood that the oil tanker of inflation expectations will begin to change course, as in the early 1970s.
Inflation Developments Through the C-19 Crisis
There have been three notable global inflation developments through 2020H1 – the period of the global C-19 pandemic.
First, the large swings in oil prices have (as always) heavily shaped overall headline inflation dynamics (Chart 3). Oil prices dipped through late April before rebounding more recently. If oil prices remain around current levels into next spring, the year-ago effect of oil prices on headline inflation will remain negative before jumping in March through May 2021, as very low prices enter the base. It is quite normal for goods price inflation to rebound in the early years of an expansion (as in 2010-11), with gains generally going beyond base effects.
Second, food price inflation has jumped (Chart 4). This mainly reflects a surge in near-term demand for food consumption at home, combined with virus-caused supply dislocations. The surge was greatest at the worst of the pandemic and has already shown signs of fading. US food prices fell in July. More significant, unrelated, food price increases affected China and India in 2019. These had been fading, although virus-related disruptions have given them renewed impetus. In India, food still accounts for about 45% of the consumption basket, so a high food inflation rate matters, especially to the rural poor.
Third, C-19 dislocations caused major declines in some key categories of core inflation, especially those related to travel and personal discretionary spending (e.g. apparel). You were not alone in wearing sweatpants and t-shirts for two months! There were also major challenges in collecting the data. The US agency responsible for collecting the CPI moved collecting prices online, raising questions about the continuity (and quality) of price series. More goods consumption was done via home delivery shopping, delivery prices rose (free delivery options declined), and delivery times increased. US core inflation plunged by far more than in other major jurisdictions (Chart 5). In Europe, the relative stickiness of core inflation is surprising and may reflect data collection difficulties. Japanese core inflation had been very weak before the crisis. The 2%-point rise in sales taxes in October barely showed in the data, although the weaker underlying trend became more evident by March 2020 as any tax-related price bump dropped out of the %3m/3m change data.
I think the slump in US core inflation will be temporary, with one important exception. I have grouped the components of the CPI most (negatively) affected by the crisis into a ‘pandemic basket’ (Chart 6). This basket of prices fell by 8.7% between February and May. They have since recovered a cumulative 5% in June and July. The exception to this bounce-back narrative could be rents, which are used to impute housing costs, including owner-occupied housing, which accounts for 24% of the overall CPI (and 30% of the core). Rents have softened through the pandemic, and this trend could well persist even in a strong rebound. The pandemic could well spur a move away from urban renting to suburban buying, similar to the shift in the years ahead of the 2008 housing crash when house prices rose relative to rents and subdued rents contributed to low measured late-cycle core inflation.
The Logic of a Flat Phillips Curve
One of the features of the last expansion was the relatively flat Phillips curve. This highlighted the apparent lack of sensitivity of wages (and prices) to the state of the economy. The relationship was there, it was just (a) muted and (b) statistically not strong.
The C-19 recession will undoubtedly leave DM economies with larger unemployment rates in 2021-22 than in 2019 (Chart 7). So far, countries have taken different paths to a higher unemployment rate: the US (and Canada) saw its rate spike early on; it is now falling steadily. Europe, Australia and New Zealand shielded the initial rise with labour support schemes; over time, unemployment rates will rise as these schemes are unwound. The dislocations of C-19 actually raised US unit labour costs in 20Q2 by almost 6% relative to 19Q2 (relatively more of the economy’s output was produced by higher-priced labour, Chart 8). This aberration is likely to be corrected over coming quarters; adding to the dispersion are the dots around the flat and weak Phillips Curve relationship.
The Reversal of Globalization
I have long argued that monolithic explanations of inflation (e.g. money growth and slack) fail to explain inflation trends.[1] In my view, a more eclectic approach is warranted. This involves applying slack more at the sectoral level and recognizing that some key prices as measured can have a perverse relationship to the cycle (e.g. housing as mentioned above). When thinking about US inflation, I am struck by how the move to low inflation has really been associated with a stagnation in goods prices (Chart 9).
In turn, this reflects: (a) hedonic pricing (we now measure inflation to be less than we used to, so our lower inflation rate is partly because we impute it to be so); (b) retail margin compression (the Amazon effect); and (c) the benefit of cheap imports via globalization (the Walmart effect).
It is unclear how the C-19 crisis, and the political reaction to it, will affect the second and third of these drivers of goods price stagnation, but my reckoning is that changed conditions in both will promote higher goods prices. The C-19 retail crisis is finally shaking out many of the weak players.
Policy and Expectations
The other factor apt to raise medium-term inflation is policy. In the US, the days of the Taylor Rule are numbered. At its September meeting, the Fed is likely to commit to a strategy where it will keep policy rates deeply negative for a period in which the inflation rate overshoots its 2% target. In reality, it is unclear how much difference this will make to actual Fed actions. In the last expansion, the Fed’s policy was very permissive throughout.
What is most concerning to me about this approach is that it is being designed partly to foster an increase in business and household inflation expectations. In the US, one-year-ahead inflation expectations have actually risen through the C-19 crisis, despite the move down in headline inflation (Chart 10). This is possibly a reflection of higher food prices or a sign that households have become more sensitive to reports of sizeable budget deficits and Fed balance sheet expansion. Market pricing of US inflation has also risen, although it remains well below that in the UK (Chart 11).
The reduction in inflation expectations and their ‘anchoring’ at a low level was a very costly macroeconomic achievement. It is puzzling why it is seen as desirable to reverse this in an effort to somehow squeeze more out of an already-flat monetary policy tube.
- See A bottom-up approach to US inflation, Suttle Economics Notes #2, 16 August 2017. ↑
Phil Suttle is the founder and principal of Suttle Economics.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)