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Mar 16, 2022
 in 
Economics

Increased risk of a period of higher inflation

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Increased risk of a period of higher inflation

The risk of a shift to a higher inflation ‘regime’ in advanced economies has risen in the last six months. Inflation has been higher for longer than expected, and price pressures are showing signs of broadening. Ongoing price shocks, strong money growth and tighter labor markets add to the risk –but long-term inflation expectations have not yet broken decisively higher. The danger of a shift to a higher inflation regime, where inflation runs at 4% or more for several years, is highest in the US where we see the probability at 20-25%. For the eurozone, we estimate the probability is less than 10%, for the UK 15%.

There has been considerable discussion over the last year about the risk of a global shift to a higher inflation ‘regime’, that is a period of several years where inflation runs at a pace of perhaps 4% a year or more in the advanced economies –which would be much higher than the average pace of the last two decades.

In our view, this risk has risen somewhat over the last six months, for several reasons:

High and sticky inflation. The headline CPI in the US reached 7% y/y in December, a forty-year high. In the eurozone, January inflation rose to 5.1% y/y, a pace not seen since the early 1990s. Core inflation in the advanced economies is also at a thirty-year high (Figure 1). Inflation has consistently run well ahead of forecasts in the last year and the longer it stays elevated, the greater the risk that a high inflation psychology becomes entrenched.

Price pressures broadening. In early 2021 most of the rise in inflation could be put down to base effects, higher energy prices and reopening effects. But this position is now hard to sustain. In the US, more than half the consumer basket is rising at a rate of 5% or above and trimmed mean inflation has topped 5%.

The Atlanta Fed measure of ‘sticky’ inflation (based on items, mostly services, where price changes are infrequent) is running at 4%, and this may contain forward-looking information (Figure 2). In the eurozone, there are also signs of broadening pressures albeit less so than in the US.

Supply shocks ongoing. Some price shocks are still working their way through the system. Supply chain issues have not gone away and may be exacerbated by the Omicron wave (e.g.via disruption at Chinese ports). Europe is being hit by a sharp rise in energy prices and in the US rapid house price growth is feeding into the shelter component of inflation (which is a large part of the CPI basket), with this process unfinished.

Monetary growth still an inflation risk. Money supply growth has eased from the very high levels of 2020, but the pace of broad money growth is still relatively strong. This implies lingering inflation risks from this source especially as money growth has been leading inflation by 12-15 months (Figure 3). In the US and Canada, six-month annualized broad money growth is over 10% –about twice the pre-Covid pace. Money growth is also elevated in Europe compared to the 2016-2019 pace, albeit less so.

Tightening labor markets. Labor market developments are a further upside risk to inflation, at least in some economies. In the US, a surge in quit rates and rising wages points to considerable labor market tightness. Data for vacancies and resignations also point in this direction in the UK. But the picture is not universally one of labor market tightness –in the eurozone, negotiated wage growth in Q3 of 2021 fell to its lowest level in twenty years (Figure 4).

So far, these factors have not led to long-term expectations of inflation becoming ‘de-anchored’. In the US, survey-based long-term expectations have risen significantly since early 2020, but have not yet clearly broken above the highest points of the last 20 years. Market-based measures such as inflation swaps have also risen in the US and Europe since June, but swaps’ estimates of 2-year inflation in two years’ time remain relatively contained (Figure 5).

However, market measures of ‘tail risks’ of high inflation have risen. In the current environment, these may be more useful than mean/median forecasts.

In the US, the Minneapolis Fed’s option-based estimated probability of inflation running above 3% over the next five years has risen to around 50% from 40% six months ago. The probability of inflation averaging above 4% over five years has risen to over 10%.

Tail risks have also risen in the eurozone but look lower. The ECB’s survey of forecasters shows about a 10% probability of inflation at 3% or more in five years, up from 5% six months ago. This risk is still lower than the probability of inflation below 1% in five years (12%), but the gap is closing fast (Figure 6).

Central banks have started to react to inflation risks. The Fed is signaling rate rises beginning in March and the Bank of England has raised rates twice. Interest rates on 12-24-month instruments have risen considerably, with even some movement in the eurozone.

The hawkish shift by central banks is a factor lessening long-term inflation risks but does not in our view offset the other factors pushing risks up. This is especially the case in the US, where we think the probability that inflation will run at 4% or more for several years is now 20%-25% (versus around 15% six months ago). For the eurozone, the risk is lower, at below 10%: it still looks to be in the very early stages a possible inflation regime change and has different inflation dynamics. The UK sits in the middle, we would estimate a 15% probability of high long-term inflation there.

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This Update Was Researched And Written By Oxford Economics, 121 St. Aldates, Oxford, OX1 1HB, England, as of February 22, 2022.
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