The COVID-19 pandemic has led to an unusual recession, and we don’t expect the recovery to be typical either. While the most important policy goals are to contain the virus, achieve full employment, and make the investments necessary for a more flexible and inclusive recovery, uncertainties and economic risks require forward-looking attention. One of the risks closely monitored by the US government is inflation.
Inflation, or the rate of change in prices over time, is not a simple phenomenon that must be measured or interpreted. Inflation, which is consistently very high, can harm household welfare, especially if it is not offset by similar increases in wages, which can lead to lower purchasing power. But inflation, which is consistently very low, leaves monetary policy in a narrower space to support the economy and could be a sign that the economy is below capacity, so there is room for further improvement. things. Indeed, an important context for current inflation risks is that as the economy recovers from the Great Recession, inflation was generally weaker than the Fed’s target during the decade before the pandemic. Headline inflation fell further during the pandemic, although there were significant differences between products and industries, as defined by the Personal Consumption Expenditure (PCE) deflator.
Pandemics the size of COVID-19 are rare, but this also means that small historical parallels can be drawn to inform policy makers. The United States demobilized from the Spanish flu and World War I in 1918, as well as from short bursts of inflation during some previous pandemic periods or large-scale reallocations of economic resources, such as its demobilization from World War II after 1945 and the resurgence in defense spending due to the Korean War. But history is not a perfect guide here. For example, the 1957 pandemic, which coincided with a nine-month recession, saw inflation weaken without a major recovery, even as the epidemic ended and the economy grew again.
In the coming months, however, we expect inflation, measured mainly due to three different timing factors: base effects, supply chain disruptions, and suppressed demand for services in particular. We expect these three factors to be temporary and their effects to fade over time as the economy recovers from the epidemic. Thereafter, the longer-term inflation trajectory is largely a function of inflation expectations. We also see an increase here, but from historically low levels to more normal levels. We explain our rationale below.
In the short term, we and other analysts expect to see “base effects” on annual inflation. Such effects occur when the base or first month of a growth rate is unusually low or high. Between February and April 2020, when the epidemic gripped the economy, the average price level, as measured by the core PCE deflator, fell 0.5 percent before starting to rise again in May (PCE inflation underlying excludes food and energy prices). , thus giving a clearer sign of inflation; however, the same base effects are expected for most price series). This unusually large price drop at the start of the pandemic made April 2020 a low base.
Twelve months later, due to the speed and magnitude of this previous drop, we expect the annual inflation growth rates for the coming months to deteriorate temporarily with such base effects. Although we do not yet have price data for March or April, assuming monthly inflation is just under 0.2 percent (equivalent to a 2 percent annual rate in line with the Fed’s target), inflation in April and May 2021 will be The basic prices of PCE during the year will reach 2.3 percent. This rate will not only be higher than recent inflation growth rates, but will also represent a sharp acceleration over current core price growth rates of 1.4 percent as of February this year. This cycle will be observed this spring, including the consumer price index (CPI) and the producer price index.
Over the next several months, this distortion in price data will fade as the base effect months roll back.
Supply chain problems
A second potential source of inflation comes from increases in production costs. If the cost of the materials needed to produce a good or service rises (think of the wood needed to build a house or the electricity needed to power a factory), a business can pass these costs on to consumers in the form of higher prices; economists call this cost inflation. In most cases, this type of inflation is temporary: the price of wood or energy rises, but then stabilizes or falls to a higher level without any additional impact on future inflation. This example highlights an important distinction between price levels and inflation; The second is the speed at which the levels go up and down.
We saw disruptions in some supply chains due to the pandemic. For example, the production of parts for goods such as automobiles has been restricted at times, especially in factories that play an increasingly central role in the global supply chain in Asia. Transportation and storage costs (location, air and sea) have also increased as cargo logistics have become more difficult. The recent crowding on the Suez Canal will add a new one to these problems in the near future. And increases in demand for certain products, such as those using computer chips, have caused unexpected supply constraints in industries like semiconductors.
As world economies recover in 2021 and beyond, they expect global supply chains to gradually improve, and in the short term, some companies may temporarily shift the additional costs that arise from these disruptions to higher consumer prices.
Especially the demand that lags behind in services.
Finally, prices for many of the most vulnerable services, such as hotels, restaurants, and air travel, have fallen due to consumer anxiety and limited demand driven by public health restrictions.
However, as more people are vaccinated during the year, the demand for services may increase and temporarily exceed the supply. This increased demand may be driven in part by many household savings accumulated during the epidemic, as well as last year’s aid payments and financial support this year. Economists characterize inflation resulting from increases in the demand for spending as demand-driven inflation.
Again, we hope it is a short-term problem first; As businesses that close or significantly reduce their services reopen, supply will increase to meet this pent-up demand. It is encouraging that at this time the formation of new companies has accelerated in recent months.
What about long-term inflation?
In the long term, an important determinant of persistent price pressures is inflation expectations. For example, when companies expect long-term prices to stay around the Fed’s 2 percent inflation target, they are less likely to adjust prices and wages due to the types of transient factors discussed above. However, if inflationary expectations deviate from this goal, prices may rise more permanently. Such an inflationary or “overheating” spiral can cause the central bank to rapidly raise interest rates, which can significantly slow the economy and increase unemployment. Economists call this scenario a “hard landing,” so inflationary pressures are risks that need to be watched closely.
It is equally important to recognize that economic “heat” does not necessarily equal overheating. We believe that the transition from a closed economy to a post-pandemic economy, driven by savings, relief funds and low interest rates, will not only generate slightly faster real inflation, but also higher inflation expectations. The rise in inflation expectations from an abnormally low level is a positive development. However, inflation expectations must be carefully monitored to distinguish between a warmer but more sustainable scenario and true overheating.
The best way to do this is to monitor various inflation expectations metrics. An example of this is the amount of inflation compensation that investors demand in the bond market. Over the next five years, markets will make inflation prices consistent with our expectations of some economic heat in the short term as the economy reopens. In the long term (the 5Y5Y series below, corresponding to a five-year period beginning five years later), investors are now assuming inflation consistent with the Fed’s target, as well as recent date.
Other data tells a similar story. The figure below shows a monthly composite measure that summarizes 22 different market and survey-based versions of long-term inflation expectations, including market rates such as those shown above, as well as household and professional surveys. This composite measure points to higher expectations, but the levels of these expectations remain at historical levels.
We believe that the most likely outlook for the coming months is that inflation will rise moderately due to the three transitory factors we discussed above, and that real inflation will return at a lower rate as it begins to move in line with long-term expectations term. This temporary increase in inflation will be consistent with the figures in American history after the outbreaks of the pandemic or wars in which the labor market is changing rapidly. However, we will carefully monitor both real price changes and inflation expectations for unexpected price pressures that may arise as the United States leaves the epidemic behind and enters the next economic expansion.