Higher inflation, but not enough to stress central banks
The United States has seen an inflation upturn that is unparalleled in the past 30 years. We must go back as far as the early 1980s to find higher monthly increases in core CPI. In this this theme article SEB’s economists discuss the risks that the current inflation surge will be long-lasting and the potential for similar processes in Europe.
Due to unexpectedly high inflation figures in recent months – combined with new signals about production and transport bottleneck problems – we have continued to adjust our inflation forecasts higher. Although upside risks have increased, we still believe inflation will not force a severe central bank tightening that would interrupt the economic recovery. Today’s production and trade disruptions are probably temporary, and we believe medium term labour market and income trends will be compatible with inflation targets.
US inflation was expected to climb when the economy reopened and consumption took off, but the upturn in the second quarter of 2021 was far stronger than anticipated. Although the most important underlying forces are temporary, supply side bottlenecks risk prolonging this period of unusually high inflation. Resurgent COVID-19 spread, especially in Asia, has caused new disruptions in international transport and value chains that have now begun to affect prices of more highly processed goods to a greater extent. Theme articles in the last two issues of Nordic Outlook have examined various aspects of inflation processes. This article, too, focuses on American conditions, but it also discusses signs of rising inflation in other countries. However, an inflation surge like that in the US seems unlikely in most European countries.
Strong consumption is driving US inflation
Inflation has been strikingly stable for a very long time. For example, over the past 30 years, core CPI (excluding energy and food) has varied in a narrow range of about ±1 percentage point. During long periods, the variations have also been considerably smaller than this. The recent upturn, with inflation of around 5 per cent, thus stands out dramatically. We must go back to the early 1980s to find higher levels, and if the trend in Q2 2021 continues, the annual rate will be above 10 per cent.
Used cars are the most important force. Above all, higher goods prices have driven the inflation rate. The upturn in goods prices has been relatively broad-based, but more than half of the core CPI upturn is due to a 50 per cent increase in used car prices. In the US these prices are affected by auctions. Among other things, bids have been pushed higher by car hire firms that are in desperate need of more vehicles, after having sold off much of their fleets when the economy shut down during the spring of 2020. Service inflation, too, has climbed above its historical trend, but this is primarily a matter of normalising the prices of various tourist services after the sharp fall early in the pandemic. High used car prices and adjustments in service prices thus account for a large share of the upturn in core inflation during Q2. Yet there are many indications that these forces are now weakening significantly. Auction prices of used cars have recently fallen somewhat, while most price declines from the initial phase of the pandemic have been reversed.
Weaker inflation impulse in Western Europe
The question now is to what extent we may see similar inflation surges in other countries. There are some similarities, but several factors suggest that the upturn in Europe will be milder. The most important driver behind the US inflation surge is probably the consumption boom that followed in the wake of direct stimulus payments to households. When these funds were distributed early in 2021, for a few months retail sales rose much faster than the historical trend. Retail sales and goods consumption have also risen in Europe, but the rate of increase is not at all as dramatic as in the US.
Various reasons for a calmer inflation upturn. Nor is there any equivalent to the inflation-driving US car auctions (with the possible exception of the United Kingdom). Used car prices have climbed at a very modest pace in Europe including the UK. In addition, the CPI weighting for used cars in Europe is only 1/3 as large as in the US. Declines in tourist and travel service prices during spring 2020 were also far smaller both in Sweden and in Europe generally, diminishing the potential for an upward inflation impulse when prices normalise. Because of earlier consumption declines, the weights of these items in the CPI basket have also been adjusted downward, for example in Sweden and the euro area, further lowering their contribution to CPI during the price rebounds that we are now seeing. The down-weighting is especially large for international travel, for which prices have previously fallen the most. We are also seeing a certain “reopening impulse” in Europe, with CPI in the euro area and in the UK expected to peak at around 3.5 per cent. Swedish inflation is not expected to exceed 2.x per cent. But inflation impulses due to price adjustments are expected to be short-lived. This view is supported by the fact that prices of US tourist services and used cars were unchanged in July.
Shifting inflation drivers
Although the forces behind the “reopening inflation” are now starting to fade, other factors will keep inflation high for another while. Production and transport disruptions seem to be increasingly serious. This is partly connected to renewed COVID-19 spread and lockdowns in Asia. Producer prices have now also begun to climb for more highly processed consumer goods, increasing the likelihood that CPI will also be affected. Producer prices have risen the most in the US, but an upturn is also discernible in Europe. Although commodity prices have fallen a bit, they are still high and earlier price increases will probably affect CPI inflation after a time lag. We still believe that food prices will climb late this year and early in 2022. To some extent, rising commodity prices will thus help fuel higher inflation, but except for oil and food, the effect will probably be small.
Can structural shifts lead to long-lasting inflation?
We thus regard the inflationary forces that have been discussed so far as short-term. Even if they turned out to be stronger than expected, it is still fairly certain that inflation will fall once consumption normalises and output disruptions are remedied. Structural problems in world trade might also possibly lead to more lasting inflationary impulses. Indicators such as shortages and capacity utilisation have already risen in many countries, especially the US. But this increase is likely to reflect bottlenecks connected to the rapid but uneven recovery and is thus not due to general overheating trends in labour markets. Yet wage trends this past year have been hard to interpret, since in many cases the statistics have been distorted by furloughs and dramatic variations in the number of people employed and hours worked. But wage metrics that correct for these effects indicate that their impact on wage increases has been small so far.
New tests of the puzzling Phillips curve. Looking ahead, the crucial question will be to what extent falling unemployment leads to rising cyclical inflationary pressures. In general, wages have long been insensitive to changes in the jobless rate. Record-low US unemployment just before the crisis, for example, generated only minor increases in the pace of wage and salary growth. Our forecasts indicate that towards the end of 2022, US unemployment will fall to pre-crisis levels. This will once again test what the Phillips curve ̶ the historical association between the labour market and price and wage formation ̶ looks like. Some structural factors may suggest slightly higher pay increases this time. Concerns about growing economic gaps have attracted greater attention in the political discourse. Higher minimum wages may, for example, lead to broader pay hikes. A slightly longer period of high inflation may also cause the Phillips curve to shift upward via rising inflation expectations. But so far, pricing in the fixed income market does not indicate any major inflationary concerns, despite high actual inflation. Market pricing for CPI inflation has rebounded after declines in 2019 and 2020, but it is not at alarming levels either in the US or Europe. Instead, the market foresees an overwhelming likelihood that inflation will fall below target within a few years' time. Such modest long-term inflation expectations reduce pressure on central banks to tighten their policies.
Due to lower international mobility and higher pay levels in certain emerging market economies, the wage-restraining power of globalisation may diminish in strength. But our main scenario is that continued keen international competition will set limits on how much a heated domestic labour market can speed up its pace of wage increases. It is also notable that the shortages of personal protective equipment and food that arose early in the pandemic were resolved relatively fast. Shortages of semiconductors, shipping containers and transport capacity should also be possible to solve, although it will apparently take a little time.
Inflation will fall despite major challenges. Sudden demand and supply shifts in various areas, combined with economic stimulus measures, pose greater challenges to the established low-inflation environment than we have seen in decades. In addition, changes in policy frameworks are giving central banks a larger mandate to "play with the fire of inflation". Inflation has clearly surprised on the upside recently and disruptions in production, transport and trade appear to be more stubborn, also increasing the upside risks in inflation forecasts. But our main scenario is still that inflation will fall enough to allow central banks to avoid drastic tightening that would stop the recovery and lead to plunging prices in the housing and stock markets. The market's pricing of inflation risks is thus fairly compatible with our forecasts.
Nordic Outlook September 2021