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Economy in Brief

Transitory Inflation, for Now!
by Andrew Cates  September 17, 2021

The big global macro debate at present about whether current inflationary pressures will shortly fade or be longer lasting has shown no signs of letting up. The data can be cut both ways depending on the specific prices that are being monitored and on the economy that is being assessed. Chinese consumers, for example, have seen pork prices decline by 36% in the year-to-date. US consumers in the meantime have seen used car prices rise by 31% over the same time frame.

However, on balance – and to this observer – those that are arguing that current price pressures are transitory have the upper hand. There are a number of reasons why.

Global inflationary pressures are still narrowly confined

The first reason concerns the breadth of current price pressures both at a country and sector-level. At the country level and among advanced economies only a handful have seen a meaningful uptick in headline CPI inflation in recent months. And if we strip out volatile components such as food and energy prices, the uptick in core inflation – which excludes those components – has been even more benign (see figure 1 below).

Figure 1: Inflationary pressures have mostly been confined to the US

China concerns

The second reason relates to a slowing Chinese economy and the impact of that slowdown on some commodity prices. Iron ore prices, for example, have weakened quite sharply in recent weeks (see figure 2 below) as has the price of lumber. Given their importance for price pressures across global supply chains this could be of some significance for international price pressures in the period ahead. As for that slowdown in the Chinese economy, the latest dataflow speaks for itself. Recent Purchasing Managers' surveys for August have been very soft and this week's August dataflow for industrial production, fixed asset investment and – most notably – retail sales all fell short of analysts' expectations. While COVID-related disruption is undoubtedly one source of this weakness, a negative credit impulse in recent months is likely to be another (see figure 3).

Figure 2: Iron ore prices have weakened quite sharply in recent weeks

Figure 3: Commodity price weakness can be traced to a negative credit impulse in China

Wage pressures are still benign

A third reason for believing current price pressures in the world economy should be transitory relates to wages, or more specifically the absence of unit wage cost pressures. In the inflation equation it is unit wage costs that matter (i.e. wage inflation adjusted for productivity growth). More productive employees, after all, can be paid a higher wage without sapping profit margins. And the latest data suggest that not only have employees become more productive they have not yet been rewarded for being so. Unit wage costs in other words are falling in year-on-year terms in most major economies (see figure 4 below).

Figure 4: Unit wage cost pressures in most major economies have been weak

Inflation expectations are under wraps

One of the reasons, moreover, why nominal wage inflation is under control at present is because inflation expectations are under wraps as well. Notwithstanding recent inflation scares, Central Banks have, for the most part, retained their inflation-fighting credibility in recent months. Most surveys that measure medium-term inflation expectations certainly attest to this. Longer-term inflation expectations from professional forecasters appear well anchored at the same time (see figure 5).

Figure 5: US forecasters expect inflation to remain low in the near-term and in the long-term

Higher debt levels and ageing demographics are disinflationary

Well-behaved unit wage cost pressures and well-anchored inflation expectations are good news for those that are arguing that current price pressures are transitory. The oft-heard refrain though from those that are more alarmed about those pressures concerns the lax nature of monetary policy. Central Banks could be still buying far too much debt and setting interest rates at levels that are dangerously low relative to the current and prospective pace of economic growth.

But are they?

Partly because of structural shifts in the world economy—the rise of automation, the advent of global supply chains, the secular shift from manufacturing activity to services and the adoption of inflation-targeting by central banks—the expected return on investment has shifted to much lower levels.

Higher levels of debt in in the aftermath of the global financial crisis and now even higher levels of debt in the aftermath of the Pandemic suggest moreover that the expected return on investment may have trended even lower. This can be seen in figure 6 below which shows the correlation between the so-called natural rate of interest in the US and stepped-up levels of government debt in recent years (those debt figure are inverted in the chart). The same argument applies incidentally to another important structural shift in the world economy, namely ageing demographics, and evidenced in figure 7. Recent academic research, for example, suggests a large negative impact on neutral interest rate levels from the ageing population profile of large developed and emerging economies in the years ahead (see Demographics in the 21st century).

Levels of real short-term interest rates that are below this natural rate indicate an expansionary monetary policy, while real short-term rates above the natural rate indicate a contractionary policy. There is no question then that monetary policy is still expansionary (as market-determined real rates are presently negative). The degree to which monetary policy settings are expansionary, however, is more open to question not least with both higher debt and ageing demographics likely to place downward pressure on natural rates in the period ahead.

Figure 6: Higher levels of debt place downward pressure on neutral real interest rate levels

Figure 7: Ageing populations place downward pressure on neutral real interest rate levels

Current price pressures are undeniably problematic for some sectors of the world economy at present. And with supply side congestion, not least in labour markets, likely to remain problematic all the while the pandemic rages those pressures could persist in the immediate months ahead. Whether those pressures morph into a more generic – and more permanent – inflation problem, however, is more questionable. The absence of follow-through to unit wage cost inflation, well-anchored inflation expectations and global monetary policy settings that are not necessarily as loose as they appear certainly challenge the 'permanent inflation hypothesis' and ought to leave Central Banks somewhat guarded about a swift policy tightening.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

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