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Economy in Brief

Macro Expectations Hold to the High Ground; Inflation Expectations Stake Out the High Ground As Well
by Robert Brusca  January 19, 2021

In January, the ZEW index paints a mixed and somewhat uneven view of its survey universe. For the most part, country/regional level data are little changed. In the aggregate, data are very little changed. The details show a larger change in expected inflation rates and in higher long-term interest rates. But even there, the monthly changes are not glaring. An overview the ZEW survey is still optimistic in terms of expectations. That optimism is also partly due to the current assessment that is so weak that given the depth of that view some optimism about things getting better in the future is pretty much a given. However, inflation expectations have been building. The average percentile standing for inflation today is at its 85.9 percentile. 12 months ago, before the pandemic struck, those expectations averaged at their 49th percentile. This is a huge shift and a developing outlook that has been advancing in spurts.

Inflation expectations at first declined precipitously in March 2020. Inflation expectations then rose by 20 percentile points month-to-month in April 2020 and again in June 2020 and by nearly 18 points in September 2020. After two months of edging lower, inflation expectations on average rose by 17 points in December 2020 and by 12.5 points in January 2021.

This is a curious progression. In Germany, the Bundesbank has just warned that the cost of the failure of virus containment would be severe. The Bank of Italy projects a 'strong' economic rebound in 2021 but one that does not come close to restoring the output lost in 2020. A just-completed fourth-quarter survey by the European Central Bank finds that Eurobanks are tightening credit standards- tightening them not easing them. Germany's financial watchdog is warning that some banks are likely to fail given the stress caused by the coronavirus. This does not sound like an overheating environment.

Everyone is looking for the next big trade. And in this environment, it is hard to find one. The ZEW average standing for stock markets is at only its 43.5 percentile- it weakened this month. Obviously, on the investment side, the ZEW financial experts are not seeing a blowout. So why is inflation so low and yet why are inflation expectations climbing so high?

You will not find much cause and effect in this survey. Yes, expectations are strong, but from a very weak base. It is likely that all the government spending and debt that has been brought to bear on the virus is a catalyst for high inflation forecasts because that would be their impact in traditional financial models. However, consider this... If a dump truck dumps a load of dirt on the expressway, traffic would come to a halt and there would be a severe traffic jam. But if there were a huge hole in the road and dump truck were to dump a load of asphalt in that hole, traffic on the expressway would unclog and go back to normal. The question is one over the state of preconditions and if preconditions are normal or not.

From that example, I wish to focus attention on how current government actions CANNOT be taken out of context. Current preconditions for evaluating government actions are not normal or anything like normal. Large parts of the private sector are simply not operative. Government spending is not piggy-backing on top of normal consumer and business activity. It is filling in for missing private sector activity. In addition, lasting damage has been done to the economy as many businesses have been destroyed and will not come back. We can't be sure how quickly new businesses will replace them.

There is very little evidence that the ZEW experts' inflation concerns represent any real or threatening issue. Inflation should rise from current very low levels, but there is no real threat of anything we would call real inflation. Governments are providing sustenance more that stimulus. And not only do we see global unemployment (or underemployment in some cases) but much of it is unemployment among people who would usually be engaged in task that are in fact prohibited by governments because of Covid-19 or shunned by consumers because of their personal fears of Covid-19. The key here is that when Covid-19 is controlled much can go back to normal. But we can all agree that what normal will be is going to be something different in the post-Covid-19 world.

However, in the new normal of the future, I still see a lot of competition, lots of online shopping and price competitiveness and price discipline remaining. In the U.S., the new president is pushing a large hike in the minimum wage and that could send a one-time rise in costs through the U.S. economic system. It also could stimulate investment and lead to fewer minimum wage jobs being offered.

On balance, the global economy continues to face a lot of risks. We are only just becoming aware of the constraints being faced in the distribution of the vaccine. There are some supply issues in the economy at large that have hiked prices 'here and there' but oil prices remain under downward pressures and the global dislocation shows signs of being present in some form or another for most if not all of 2021. Some countries will recover sooner than others. But the fear of inflation or forecast of it as reflected in this survey seems excessive.

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