By Stuart Cole, Head Macro Economist at Equiti Capital

The 2008 financial crisis saw monetary policy predominantly used as the tool for ensuring economic recovery, fiscal policy kept under control as governments sought to repair balance sheets.  The coronavirus pandemic, however, has seen fiscal rectitude largely abandoned, governments spending heavily to support jobs and incomes while central banks have expanded quantitative easing programmes and cut interest rates to boost activity.  While economies have been in lockdown, the inflationary consequences of this money supply expansion have been largely benign, demand insufficient to allow any sustainable price rises.  But as lockdowns are lifted and consumption restrictions removed, fears over these inflationary consequences have started to rise, fuelled by rising CPI releases and central bank inaction.

This debate is becoming increasingly relevant in the US, where April’s CPI reading jumped to its highest level since 2009.  For the Fed, rising prices are transitory, meaning policy metrics can remain ultra-loose, tightening seen as risking stifling the economic recovery.  But for the markets inflationary pressures look more sustainable, the consequence of the unprecedented level of stimulus being provided which needs scaling back now if inflation is not to spiral higher.

Are inflationary pressures transitory or sustainable?

Whether emerging US inflation is transitory or sustainable depends on its root cause.  The Fed’s argument is that pandemic-created disruptions to supply chains and production lines have inevitably created bottlenecks, causing temporary price rises while producers work to raise output.  Evidence of this can be seen in the strong US car rental prices recorded in April.  But the more worrying scenario is that we are seeing the consequences of the increase in aggregate demand engineered by the authorities.  With US output already back close to pre-pandemic levels, prices are being pulled upwards as demand outstrips supply, and with the added fear that the quantity of economic stimulus provided means this demand will exceed even full US output.  Under this scenario increased demand will cause higher prices which will in turn trigger higher wages claims as labour attempts to maintain real spending power, i.e., classic demand-pull inflation.  Adding to these fears are concerns that we are only just at the beginning of this cycle in respect of US services.  Already rising in price, services are expected to see the strongest recovery in demand as the US re-opens and will provide fertile ground for sustained price rises as consumers look to materially increase consumption.

Is the real story an increase in the natural rate of unemployment?

However, despite ‘transitory’ versus ‘sustainable’ being the inflation focus so far, the suggestion is that rising prices are possibly a reflection of something else.  Potentially more worrying for the Fed is if we are seeing evidence of a rise in the natural rate of US unemployment.  So far inflation has been seen as something to worry about in the future.  But if the post-pandemic US economy is now operating at a higher natural rate of unemployment, then the Fed’s assumptions on the labour demand/supply equilibrium required to close the output gap will be wrong and its current policy stance likely to do nothing except drive inflation higher.

Inflation expectations creeping higher

Inflation expectations matter too.  If consumers see their real spending power being eroded, they will demand higher wages to compensate.  Until recently, evidence suggested the US markets believed the Fed would not lose control of inflation, the 5-year/5-year forward expectation rate showing expectations lower over 2026-2031 than over the next five years, i.e., CPI rises were seen as transitory.  But the latest Michigan survey showed consumer 5-year/10-year inflation expectations rising to 3.1%, pointing to higher prices starting to be viewed as more sustainable and potentially threatening upwards pressure on wages claims.  To date, a central pillar of the Fed’s strategy has been to rely on excess unemployment to hold down wages rises and absorb these inflationary pressures: if dependency on labour resources has fallen then this downwards pressure will be eroded, increasing the pressure for a change in policy stance instead.

The Fed to change its policy guidance?

As the US emerges from the Covid pandemic, the argument that initial inflationary pressures are transient is hard to rebut.  Some supply bottlenecks are inevitable as production reacts to meet re-emerging demand.  But with the recovery accelerating, the proposition is that these transitory pressures are already becoming more sustainable, and that this may possibly be a consequence of the post-pandemic US economy evolving to operate with a structurally smaller labour force.  If this is the case, then a failure to remove the excess stimulus provided to date leaves current Fed policy at risk of simply fuelling an inflationary spiral.  It also renders questionable its use of higher unemployment as a tool to bear down on emerging inflationary pressures.

With rising commodity prices providing further evidence of demand outpacing supply, and surveys showing US inflation expectations rising, the suggestion is that the Fed will soon be forced to drop its ‘transitory inflation’ argument and change its policy stance, essentially moving more in line with market thinking.  The suggestion is that this shift will be required before year-end.

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