Inflation: up, up and away?
By Henk Potts, London UK, Market Strategist EMEA
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- Pent-up demand and fiscal programmes fuel inflation forecasts
- Projected UK, Europe and US headline inflation may be one percentage point higher than 2020 this year on last
- US, eurozone and UK central banks to keep rates on hold this year and next
- Diversification key to weathering inflation.
A shockwave has reverberated through financial markets since February as the unleashing of pent-up demand, overwhelming fiscal support and surging commodity prices encouraged several economists to hike their inflation forecasts. In fact, we now project that the global economy will grow at 6.4% this year, up from a 5.6% forecast in January.
Inflation expectations have been boosted by the scale of the global fiscal response. The International Monetary Fund estimated in January that governments have committed $14tn to saving lives and livelihoods1. President Biden’s $1.9tn relief bill, the second largest stimulus package in US history, was passed in mid-March2.
Accelerating commodity prices can quickly influence inflation projections given their high weighting in consumer price indexes. Inflation is also being driven higher by technical factors, including disruption in global trade caused by coronavirus protocols which has resulted in supply bottlenecks, pushing up costs in areas such as container shipping.
Given the broad range of both demand pull and cost push inflationary pressures, it's perhaps no surprise that for the UK, Europe and US headline inflation is projected to be one percentage point higher this year than in 2020.
We forecast that the Fed, European Central Bank and Bank of England will keep rates on hold this year and next.
While it appears that inflation rates are currently not sufficiently concerning to worry central banks, even moderate price rises can start to cause meaningful damage to wealth preservation assumptions. For those seeking protection, there are a wide range of options available to mitigate inflation risk by using equities, fixed income and precious metals.
With hopes rising of a relatively swift, vaccine-fuelled recovery for some of the largest economies this year, does the prospect of a bounce in prices beckon? We look at inflation prospects and what these might mean for policymakers and investors.
A shockwave has reverberated through financial markets since February as the unleashing of pent-up demand, overwhelming fiscal support and surging commodity prices encouraged several economists to hike their inflation forecasts. Similarly, government bond yields have climbed as investors revaluated central banks’ commitment to maintaining interest rates at historically low levels for a prolonged period.
Investors must now gauge if the anticipated rise in inflation is persistent, whether it will result in higher interest rates and consider the need to adjust portfolios to mitigate the risk.
Recovery hopes strengthened
Inflation expectations have been rising as confidence in the speed and magnitude of the recovery climbs. Lower levels of reported coronavirus cases have allowed governments to plan for the gradual easing of restrictions.
Most importantly, the administering vaccines around much of the world has accelerated the timeframe for the normalisation of activity. The vaccine rollout should reduce new infections, help revive service industries and eventually help to restore employment prospects. We now project that the global economy will grow at 6.4% this year, up from a 5.6% forecast in January.
Building price pressures
Inflation expectations have been boosted by the scale of the global fiscal response. The International Monetary Fund estimated in January that governments have committed $14tn to saving lives and livelihoods1.
President Biden’s $1.9tn relief bill, the second largest stimulus package in US history, was passed in mid-March2. The bill includes direct cheques to consumers, extension of unemployment benefits and funds for vaccination distribution programmes. The aid should temporarily supplement income and government spending while the economy is being weighed down by the pandemic.
Spotlight on commodities
Accelerating commodity prices can quickly influence inflation projections given their high weighting in consumer price indexes. The anticipated robust recovery (particularly in commodity-intensive economies such as China), aggressive infrastructure investment and the climate change agenda have conspired to push energy, metal and agricultural prices higher.
The total return on the Bloomberg Commodity Index is 34% over the past year. Investment houses are increasingly predicting a commodities super cycle is playing out. If commodity prices maintain their upward trajectory they would push both consumer and producer prices higher, particularly in countries that have to import vast amount of raw materials.
Inflation is also being driven higher by a range of technical factors. Disruption in global trade caused by coronavirus protocols has resulted in supply bottlenecks, pushing up costs in areas such as container shipping. Countries, such as Germany, have reversed VAT cuts introduced at the start of the pandemic and there have been delays to key selling seasons. Relatively small increases in prices can also result in dramatic inflation movements due to low base levels.
Inflation set to climb
Given the broad range of both demand pull and cost push inflationary pressures, its perhaps no surprise that year-on- year inflation prints could significantly rise over the course of this year. For the UK, Europe and US headline inflation is projected to be one percentage point higher this year than in 2020.
Are pricing pressures temporary or sustainable?
A number of factors suggest that the inflationary pressure being seen is transitory. Unemployment rates are elevated compared to pre-pandemic levels, yet the wage growth often associated with core inflationary pressures has not being seen. The rapid digitisation and ongoing investment in technology is also expected to keep wage growth muted, even when labour markets recover.
Furthermore, the level of spare capacity in many economies remains high compared to the start of the recession which should help anchor inflationary pressures.
While the medical prognosis has improved, the arresting of the coronavirus outbreak is far from assured. The road to freedom could still be infringed upon by regional differences in vaccination rates. Unknown vaccine efficacy levels against future variants could also affect the recovery in demand and, in turn, price pressures.
Barclays forecasts that the core personal consumption expenditures (PCE) index, the US Federal Reserve’s (Fed) preferred measure of US inflation, will hit 2.2% in the second quarter of this year, easing back to 1.8% in the third quarter and 1.9% in the fourth one and then averaging 1.8% in 2022.
In Europe inflation forecasts have risen, but weak underlying consumer prices pressure from the fragile labour market is expected to keep inflation subdued in the medium term. The euro area CPI will likely average 1.5% this year and drop to 1.1% in 2022. In the UK our inflation projections are for CPI to average 1.9% this year and 1.8% next.
Is tighter monetary policy on the horizon?
Given that inflation forecasts remain below central banks’ mandated levels, the impact of stronger inflationary pressures on monetary policy is likely to be more muted than recent movements in bond yields suggest. We forecast that the Fed, European Central Bank and Bank of England will keep rates on hold this year and next. Central bankers will, however, closely monitor rising yields and may want to discourage an unwarranted tightening of financial conditions.
In order to cap the rise in yields, policymakers still have a range of tools available, including implementing a higher bond purchase rate, buying longer dated bonds while simultaneously selling bonds with shorter maturities (known as Operation Twist) and, if required, the introduction of formal yield control measures.
In order to preserve the long-term purchasing power of their wealth, investors need to generate a return that is equal to or preferably higher than inflation. While it appears that inflation rates are currently not sufficiently concerning to worry central banks, even moderate price rises can start to cause meaningful damage to wealth preservation assumptions. For those seeking protection, there are a wide range of options available to mitigate inflation risk by using equities, fixed income and precious metals.
Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.
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