Nicholas Rilley
Over the past couple of years, pandemic-related distortions in the global economy, combined with immense government policy responses to the COVID-19 crisis, have succeeded where years of central bank quantitative easing programmes have failed: They generated inflation.
US headline CPI inflation soared to a 40-year high of 7.5% year-over-year in January; above expectations of an acceleration to 7.3% from December’s 7.0%. Other key inflation measures offered no relief as Core CPI (inflation excluding the volatile food and energy components) rose from 5.5% to 6.0%. In the UK, CPI hit 5.5% in January and could peak above 7% in April; even in the famously disinflationary single-currency Eurozone, inflation is above 5%.
The debate around the inflation outlook intensified early last year as vaccines were rolled out and governments continued to pour money into economies to support growth. This was facilitated by central banks committing to hold interest rates at very low levels and buying government bonds. Inflation was expected to pick up as the global economy reopened, with initial pressures felt in the sectors most exposed to pandemic-related distortions, such as used vehicles, car rentals and airfares.
As we progressed through the second half of last year, it became clear that inflationary pressures were broader based. Food and energy prices tend to be volatile so excluding them is a common way to better gauge the real underlying inflation rate. However, rising commodity prices across the energy complex, base metals, agricultural and chemical products provided a shock to the system and continue to work their way through global supply chains, making their way to end consumers. The shift in spending from services to goods through the pandemic has also put pressure on global supply chains, while closures, social-distancing measures and absenteeism has constrained production around the world.
Wage growth has also been strong, especially at the lower end of the distribution. The pandemic has kept people away from work for a number of reasons: health concerns, child care and home schooling requirements, and early retirement. The number of people quitting their jobs since the start of the pandemic has even been dubbed ‘The Great Resignation’; a phenomenon so significant it has its own Wikipedia page.
Stepping back, governments pouring money into economies to limit the economic fallout from the pandemic does not come without cost. Contrary to popular opinion, free lunches can exist in economics if governments stimulate economies when there is a lot of spare capacity – too many people are saving relative to investing and interest rates are therefore very low. However, that is very different to the current situation.
While high inflation is a better way of paying the COVID bill than high unemployment, it is painful and particularly so for those on low or fixed incomes. By some measures, consumer confidence in the US has plunged to decade lows. News in the UK is dominated by the cost of living crisis and so, with jobs plentiful, central banks have turned their attention from supporting growth and employment to fighting inflation.
The primary cause of this inflation is pandemic-related distortions (the shift from buying services to goods, combined with production bottlenecks) and governments injecting money into the economy to limit the economic fallout. While central banks have helped facilitate this government spending, their tools are not well suited to tackle these inflationary issues – making mortgages more expensive won’t do much to solve a cost-of-living crisis.
Inflationary pressures are less acute in Europe and the European Central Bank has been more vocal about the risk of tightening policy too quickly compared to the Bank of England or Federal Reserve. ECB president Christine Lagarde recently warned that “if we acted too hastily now, the recovery of our economies could be considerably weaker and jobs would be jeopardised”. Her ECB colleague Olli Rehn put it more bluntly: “if we reacted strongly to inflation in the short term, we would probably cause economic growth to stop”.
The history of inflation in the 1970s suggests that it is very difficult for central banks to engineer a soft economic landing after an inflationary shock. However, it is important to recognise that the nature of this pandemic crisis is extremely rare. Historical case studies that may be seen as relevant for understanding what is going on today are the post-war reopening episodes, when firms had to switch from production of military equipment back to consumer goods.
Given that inflation is now such a drag on real incomes and therefore the growth outlook, it is understandable central banks want to tighten policy and get rates back to a level they feel is more of a neutral setting. Geopolitical tensions and the pandemic situation in China are notable risks to the outlook, and trouble here could compound inflationary pressures, but pandemic distortions are easing as economies reopen and government support programmes are now being withdrawn.
If inflation rates peak this spring as consensus expects, then central banks can tighten policy in a measured and pragmatic way. This would help engineer a soft, rather than hard, economic landing.
Nicholas Rilley, CFA, is Investment Manager and Strategy Analyst at Butterfield Asset Management.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
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