Inflation expectations have been rising considerably around the world, especially in the US, the European Union (EU) and the UK. According to new data on the state of inflation in the US published on June 10 this year by the US Department of Labor’s Bureau of Statistics, the consumer price index (CPI) increased 5 per cent from May  2020 to May 2021– the biggest jump in nearly 13 years.

Also, since the beginning of this year, breakeven inflation rates (breakeven inflation rate is market-based expected inflation)  have been increasing in the UK and the EU. The breakeven inflation rate is viewed a more reliable measure of inflation expectations than those measured by surveys. As a consequence, the fear of rising inflation is back into focus.

The latest trend in the rise in inflation in the US has made financial markets, especially the bond market very jittery. Bonds are subject to interest rate risk because rising interest rates will result in falling bond prices and vice versa. Interest rates respond to inflation. When inflation rises, the central bank hikes up the target interest rate. Because of these linkages, bond prices are quite sensitive to changes in inflation and inflation forecasts. Inflation also erodes the real value of a bond. Interest rates, bond yields and inflation expectations correlate with one another.  In fact, inflation is the worst enemy of a  bond. So, investors, in general, must brace for a wide range of inflation outcomes and the consequent impact on their portfolios.

Furthermore, the emerging concerns about the rise of inflation speculations are not just the result of immediate economic forces but also reflect longer-term changes in the structure of the global economy. Leaving aside the aggressive economic stimulus to deal with the Covid-19 pandemic,  there are other issues of concerns such as the decline in the working-age population in industrialised countries including China, a green tech revolution overhauling 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 get out of hand in the coming months and May’s inflation figure, as Federal Reserve Chair Jerome Powell asserted, is a transitory event. Central banks in the UK and the EU also say that these price rises are a temporary phenomenon. Overall, even if inflation continues to rise, Central bankers are confident that they can rein it back in.

Most central banks’ mandate, 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 per cent on average (the target rate). If inflation rises above the target rate, and longer-run inflation expectations are moving above the long run target rate, central banks will use interest rate hikes to bring the inflation rate down to the target rate. 

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The White House Council of Economic Advisers also believe that the current spike in the Consumer Price Index (CPI) which measures the rate of inflation is due to the “base effect” of rising from very low inflation in 2020 caused by the pandemic. Therefore, the hike in the inflation rate is a transitory surge.

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 scene for wage negotiations or price setting which becomes a self-referencing point for deciding on wages and prices, even it can cause a self-sustaining wage-price spiral;  second, changes in both short term and long-term inflation expectations affect real interest rates ( nominal interest rates minus inflation expectations) impacting on household consumption and business investment. The real risk is that as inflation expectations rise, they become embedded in consumer behaviour and business decisions.

Therefore, rising inflation expectations can put into question the credibility of the central bank’s ability to achieve its inflation target which in turn makes it difficult for monetary policy to stabilise inflation and output. Therefore, the central bank to achieve its monetary policy objectives strives to anchor inflation expectations at its target rate, e.g. at 2 per cent.

Every major central bank like the US Federal Reserve, the ECB, the Bank of England, the Bank of Japan shares the same target inflation rate at or close to 2 per cent. The message is clear – interest rates will remain very low to even move into a negative zone like in Europe and Japan making mortgages and business loans cheaper. Such a policy has resulted in asset price inflation where prices of property, stocks and shares continue to rise. This has made the rich richer widening income inequality.

Also,  the Austrian School, like the monetarist see a link between increased money supply and higher prices. But they do not assume that increased money supply will automatically result in economy-wide inflation. Instead, inflation most likely to be expressed in specific sectors such as right now happening in housing, stocks and any other means to get out of the dollar and into something that will appreciate in value over time.

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At the same time consumer price inflation as reflected in the CPI  remained persistently below the 2 per cent target inflation rate. As such there was not much real wage growth over the last couple of decades or so further adding to rising income inequality.

The idea is– if everyone expects the central bank to achieve inflation of 2 per cent, then consumers and businesses are less likely to react when inflation rises temporarily above 2 per cent or falls below it. This is the logic behind  Federal Reserve Chair Powell’s view that the rise in the CPI was “transitory”. But historically speaking, turning points in inflation occur with little warning.

In fact, the Federal Reserve modified its monetary policy framework in the middle of the last year. While sticking to its 2 per cent target inflation rate, it now tries to average out periods above 2 per cent inflation with periods below 2 per cent inflation rate, calling it Average Inflation Targeting (AIT). Therefore,  ensuring the market that it will remain on course to achieve the 2 per cent average inflation target rather than fixated on 2 per cent at all times. Such a policy change indicates that the Federal Reserve is now ready to allow inflation to rise above the target rate of 2 per cent inflation to boost employment to help stimulate the economy. Also, 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. Economists’ focus on inflation expectations reflects the academic discourse on inflation expectations as the key to understanding the relationship between inflation and unemployment. Milton Friedman and Edmund Phelps argue that the persistently high inflation in the 1970s and the 1980s caused inflation expectations to become unanchored and rise with actual 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 can not be brought down if inflation expectations remain high.

Both inflation and inflation expectations are driven primarily by current economic conditions. There is a growing trend in a reversal of long-standing downward pressures on wages and prices caused by labour supply shortages as reflected in the narrowing of the GDP gap ( the difference between actual and potential GDP), especially in the US averaging about 2 per cent now. Also, real GDP of the US grew at a 6.4 per cent annualised rate in the first quarter of 2021 and is expected to soon surpass its Pre-pandemic levels. As Okun’s law postulates a positive relationship between output and employment, the narrowing of the GDP gap indicates a tightening of the labour market.  This creates the possibility of a self-sustaining wage-price spiral.

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Furthermore, the pandemic drove fiscal and monetary stimulus led to spending in excess of the capacity of the economies to provide goods and services. Overall an economic situation has emerged where rising demand and constrained supply can lead to creating inflationary pressure. The post-Covid 19 economic recovery in all likelihood will be marked by a longer-term mismatch of supply and demand, pushing up prices.

Larry Summers, the former US Treasury Secretary also argues that the government’s fiscal stimulus will create demand far beyond the economy’s present output capacity, risking persistent inflation. In fact, the third US fiscal stimulus package of US$1.9 trillion ( about 9 per cent of US GDP)  has coincided with the current rising inflation expectation in the US. The EU also has rolled out a sizeable stimulus package of US$2.2 trillion ( about 12 per cent of EU GDP).

Central banks like the US Federal Reserve and the ECB are comfortable with the current surge in inflation and that feeling is premised on the thinking that inflation will not be a problem because it has not 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 outstrips supply. Right now, a lot of money is sloshing around and consumers are flush with cash, thanks to Covid-19  related stimulus packages. There is also now an upward pressure on wages which is likely to continue as the labour market is tightening. More importantly, the recent price rises in certain sectors were quite robust in most advanced economies. Therefore, it is clearly becoming evident that the recent price rises are not all that “transitory”. There is a strong likelihood that a significant turning point is emerging, where controlling price rises may prove to be very difficult.

By Muhammed Mahmood

(Disclaimer: This article was originally published at FE. The opinions expressed are the personal views of the author. The facts and opinions appearing in the article do not reflect the views of ApaNa and ApaNa does not claim any responsibility for the same.)

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