Rising inflation expectations around the world
Muhammad Mahmood |
July 03, 2021 8:06:43 PM
Inflation expectations have risen dramatically around the world, particularly in the United States, the European Union (EU) and the United Kingdom. According to new data on the state of inflation in the United States released on June 10 of this year by the Bureau of Statistics of the United States Department of Labor, the Consumer Price Index (CPI) rose 5% from May 2020 to May 2021 – the biggest leap in almost 13 years.
Additionally, since the start of this year breakeven inflation (breakeven inflation is expected market-based inflation) have increased in the UK and the EU. The breakeven inflation point is considered to be a more reliable measure of inflation expectations than those measured by surveys. As a result, the fear of rising inflation is coming back to the fore.
The latest upward trend in inflation in the United States has made financial markets, especially the bond market, very nervous. Bonds are subject to interest rate risk because rising interest rates will cause bond prices to fall and vice versa. Interest rates react to inflation. When inflation rises, the central bank raises the target interest rate. Because of these links, bond prices are quite sensitive to changes in inflation and inflation expectations. Inflation also erodes the real value of a bond. Interest rates, bond yields and inflation expectations correlate with each other. In fact, inflation is a bond’s worst enemy. So investors in general should be prepared for a wide range of inflation results and the resulting impact on their portfolios.
In addition, new concerns about rising inflationary speculation are not only the result of immediate economic forces, but also reflect longer-term changes in the structure of the global economy. Leaving aside aggressive economic recovery to deal with the Covid-19 pandemic, there are other areas of concern such as the declining working-age population in industrialized countries including China, a technology revolution green reworking most industrial processes, increased demand for metals such as copper and cobalt, iron ore and crude oil.
However, the US Federal Reserve has assured that it does not expect inflation to run out of control in the coming months and the May inflation figure, as stated by the Federal Reserve Chairman. Jerome Powell, is a transitional event. UK and EU central banks also say these price hikes are a temporary phenomenon. Overall, while inflation continues to rise, central bankers are confident they can get it under control.
The mandate of most central banks, including the Federal Reserve and the European Central Bank (ECB), is to achieve low unemployment and price stability. In this context, the latter is defined as an annual inflation rate of 2 percent on average (the target rate). If inflation exceeds the target rate and long-term inflation expectations move above the long-term target rate, central banks will use interest rate hikes to bring the inflation rate back to the target rate. .
The White House Council of Economic Advisers also believes that the current rise in the Consumer Price Index (CPI) which measures the rate of inflation is due to the “base effect” of the rise in the very low inflation in 2020 caused by the pandemic. Therefore, the rise in the inflation rate is a transitory push.
Inflation expectations are simply the rate at which consumers, businesses and investors expect prices to rise in the future. Inflation expectations are important for a number of reasons. First, it sets the stage for wage negotiations or price fixing which becomes a point of self-reference for deciding wages and prices, even if it can cause a self-sustaining wage-price spiral; second, changes in short- and long-term inflation expectations affect real interest rates (nominal interest rates minus inflation expectations) having an impact on household consumption and business investment. The real risk is that as inflation expectations rise, they become part of consumer behavior and business decisions.
Therefore, rising inflation expectations can call into question the credibility of the central bank’s ability to meet its inflation target, making it difficult for monetary policy to stabilize inflation and output. Therefore, to achieve its monetary policy objectives, the central bank tries to anchor inflation expectations at its target rate, for example at 2%.
All major central banks like US Federal Reserve, ECB, Bank of England, Bank of Japan share the same target inflation rate at or near 2%. The message is clear: interest rates will stay very low and even go negative like in Europe and Japan, making mortgages and business loans cheaper. Such a policy has resulted in asset price inflation where the prices of real estate, stocks and stocks continue to rise. It made the rich richer by widening income inequalities.
Moreover, the Austrian school, like the monetarist, sees a link between the increase in the money supply and the rise in prices. But they do not assume that an increase in the money supply will automatically lead to economy-wide inflation. Instead, inflation is likely to be expressed in specific sectors such as housing, stocks, and whatever else you can get out of the dollar and look to something that will appreciate in value over time.
At the same time, the rise in consumer prices, as reflected in the CPI, has remained consistently below the target inflation rate of 2 percent. As such, there hasn’t been much growth in real wages over the past two decades, which has further compounded income inequality.
The idea is this: if everyone expects the central bank to hit 2% inflation, consumers and businesses are less likely to respond when inflation temporarily rises above 2% or falls below. This is the logic behind Federal Reserve Chairman Powell’s opinion that the CPI rise was “transient.” But historically speaking, turning points in inflation come with little warning.
In fact, the Federal Reserve changed its monetary policy framework in the middle of last year. While sticking to his target inflation rate of 2%, he now tries to average periods above 2% inflation with periods below 2%, which he calls Average Inflation. Targeting (AIT). Therefore, assure the market that it will stay on track to meet the 2% average inflation target rather than stuck at 2% at any time. Such a policy shift indicates that the Federal Reserve is now poised to allow inflation to exceed the target rate of 2 percent inflation to boost employment and help stimulate the economy. Additionally, the ECB is considering an AIT as it reviews its monetary policy this year.
Inflation expectations have played a very important role in standard monetary theory. The emphasis by economists on inflation expectations reflects academic discourse on inflation expectations as the key to understanding the relationship between inflation and unemployment. Milton Friedman and Edmund Phelps argue that persistent high inflation in the 1970s and 1980s caused inflation expectations to become unanchored and rise with real inflation – a phenomenon known as a wage-price spiral. . The wage price spiral is indicative of a situation where even in the presence of high unemployment, inflation cannot be reduced if inflation expectations remain high.
Inflation and inflation expectations are determined primarily by current economic conditions. There is a growing trend towards reversing long-standing downward pressures on wages and prices caused by labor shortages, as evidenced by the narrowing of the GDP gap (the difference between the Real and Potential GDP), especially in the United States, averaging around 2% currently. In addition, real GDP in the United States grew at an annualized rate of 6.4% in the first quarter of 2021 and is expected to soon exceed pre-pandemic levels. Since Okun’s Law postulates a positive relationship between output and employment, the narrowing of the GDP gap indicates a tightening of the labor market. This creates the possibility of a self-sustaining wage-price spiral.
In addition, the fiscal and monetary stimulus measures induced by the pandemic have led to spending beyond the capacity of economies to provide goods and services. Overall, an economic situation has arisen in which growing demand and limited supply can lead to the creation of inflationary pressures. The post-Covid 19 economic recovery will in all likelihood be marked by a longer-term mismatch of supply and demand, pushing up prices.
Larry Summers, the former US Secretary of the Treasury, also says the government’s fiscal stimulus will create demand far beyond the economy’s current productive capacity, risking persistent inflation. In fact, the third US fiscal stimulus package of $ 1.9 trillion (about 9% of US GDP) coincided with the current rise in inflation expectations in the United States. The EU has also rolled out a significant stimulus package of US $ 2.2 trillion (around 12 percent of the EU’s GDP).
Central banks like the US Federal Reserve and the ECB are comfortable with the current surge in inflation and this sentiment is based on the idea that inflation won’t be a problem because it hasn’t been. a problem for a long time. In fact, there has been a long term trend towards deflation in the global economy.
Prices rise when demand exceeds supply. Right now, a lot of money is circulating and consumers are bursting with money, thanks to the stimulus packages linked to Covid-19. There is also now upward pressure on wages which is expected to continue as the labor market tightens. More importantly, recent price increases in some sectors have been quite robust in most advanced economies. Therefore, it becomes clearly evident that the recent price increases are not so “transient”. It is very likely that a significant turning point is emerging, where controlling price increases can prove very difficult.