March Economic Update: The great reflation story

While the rollout of vaccines has gained momentum in the US and the UK but continues to disappoint in the eurozone, higher headline inflation and prospects of more to come have dominated headlines and pushed up bond yields. In fact, inflation, or better the lack of it and the prospect of a lot of it, has been a darling subject in recent years. The recent increase in inflation numbers has brought the old controversy back between “inflation will remain low for a long while” and “inflation isn't dead; it was only asleep and will return with a vengeance”.

So, where do we stand in this debate?

In short, as good economists, we stand somewhere in the middle: the era of meagre inflation seems to be over, but that doesn't necessarily mean hyperinflation is around the corner. The longer answer to this question requires in-depth consideration and a distinction between the US and the eurozone.

Let’s start at the beginning. The current increase in headline inflation numbers across the world is almost exclusively driven by higher energy prices and some supply-side disruptions. The harsh winter in Texas and in other parts of the world, some production cuts and the expectations of a pick-up in global demand pushed up prices. This energy price inflation is likely to show up in headline inflation numbers at least until the summer. It would then be accompanied by reopening inflation, which in our view would mainly be in services, which should boom once economies finally reopen. Think of your favourite restaurant, which might charge a Covid-19 premium once they reopen.

Other hospitality services or leisure services are also likely to see price increases, be it on the back of higher costs to make a business Covid-19 proof or on the back of trying to make up for some lockdown losses. These examples also show that these price mark-ups are likely to be capped by the level of competition. The higher the competition in a sector, the shorter the period of price mark-ups. Let’s return to our favourite restaurant. Of course, we'll be willing to pay a surcharge a couple of times, but after a few visits, we might start looking for other restaurants that are similarly appetising but with a lower bill. 

Besides the one-off factors, there is the ongoing debate about whether the US fiscal stimulus could lead to an overheating of the US economy - too much money chasing too few goods essentially. Sure, it's possible. But what is more realistic is that destroyed production capacity and low labour market participation rates provide sufficient room to absorb strong demand without inflation. In the eurozone, the risk of too much money chasing too few goods is even lower. In our view, the eurozone economy will reach its pre-crisis level a year after the US economy. Even if the full amount of the European Recovery Fund is disbursed in the second half of the year, it is too little to spark fears of overheating. The eurozone would require governments to decide and allow for significant (minimum) wage increases to tackle social inequality and start a traditional textbook wage-price spiral.

The strong disinflationary forces of the last decade seem to be fading away. China’s demand for commodities continues. The world economy is unlikely to return to its heyday of globalisation any time soon, and disinflationary policies like structural reforms and austerity are out of fashion. But the substantial untapped resource of labour globally and digitalisation and automation should prevent ageing economies from seeing higher wages. So, structurally, we see disinflationary forces becoming stronger than inflationary forces, but headline inflation will remain elevated nonetheless, possibly even going into 2022, before falling back to significantly lower levels.

For central banks, such a scenario is challenging. For example, as much as the Federal Reserve and the European Central Bank have been working and hoping for inflation to finally return to target, inflation mainly driven by supply-side shocks and one-off factors wasn't the kind of inflation they were looking for. Instead, this is basically deflationary inflation. Reacting with tighter monetary policy would run the risk of choking off the recovery prematurely. Consequently, most central banks will try to sit out the current surge in inflation and bond yields, capping it with words and potentially even counterintuitive easing, at least for as long as the recovery remains fragile and the pandemic hasn't been contained. 

However, once Covid-19 becomes a distant memory, the discussion will change. But that won't happen until the other burning issue - lockdowns - has finally been closed.