Inflation normalisation will require quarters of patience and policymaker skill

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we assert that now is the time for an adept tightening of monetary policy in order for inflation to moderate later this year while supporting economic growth.

 

Need to know Inflation remains high in the developed world and shows little sign of easing in the short term.  But labour-market strength and rising costs, as identified by our nowcasting indicators, signal the beginning of a more measured stage to this inflationary shock.  In the coming quarters, inflation could moderate gently – with US inflation ending the year between 3%-4%. But this depends on policy tightening in the context of wage growth, commodity prices and the value of the US dollar.

 

Keeping pace with inflation

The latest US inflation report ran against the case for transitory inflation. If the +7% year-on-year reading from the December report had been enough to shake the Federal Reserve (Fed) committee , the January report must have acted as an electric shock: on a year-on-year basis, US consumer prices rose 7.5%

Transitory or not, the situation is clearly no longer consistent with the Fed's policy.g

The situation for the European Central Bank is not very different either. At the centre of the factors explaining inflation’s surprising progress lies the strength of demand. So what is the situation currently? The answer lies somewhere between nowcasting inflation surprises and understanding the factors that could moderate demand in the quarters to come.

Our nowcasting indicators, presented below, allow for real-time monitoring of three key dimensions of the economic cycle: the risk of a recession, the risk of an inflation shock and the risk of a monetary policy surprise. A key message to emerge from an inspection of these charts across the three major economic zones (the US, eurozone and China) is that global growth remains solid, inflation is showing signs of moderation and the risk of a monetary policy shock remains very present.

This conclusion may come as a surprise if one looks only at the latest consumer price indices in the US and the Eurozone. How can we reconcile these two messages, which may seem contradictory at first?

 

Second stage

An analysis of the sub-components of our inflation surprise nowcasting indicator for the US provides some answers (see figure 1). The indicator consists of four main metrics: indicators for economic activity, costs, labour markets and a time series measuring the strength of the US housing market. An analysis of how these components evolved between June 2020 and today provides an unambiguous observation.

Between June and December 2020, all four components began to rise at a pace rarely observed, bringing our indicator to same level of other inflationary shocks this century: 2007, 2011 and 2017. The indicator has slowed down recently, suggesting a decline in the probability of an inflation shock, rather than a decline in inflation. While the indicator peaked in December 2020 due to the intensity of economic activity and an increase in real estate prices, the situation has changed today.

Two factors have slowly but significantly intensified: employment and production costs, which explain the indicator’s slowdown even though economic activity and the housing component are not as strong as they were in December 2020. This leaves little room for doubt. We have reached the second phase of an inflationary shock – the phase that requires less accommodative monetary policy, which is arguably an understatement given the realised inflation figures. The US labour market is tight and production costs have risen. These are the two key ingredients of a second-round effect, a constant that should sound a warning signal in the minds of central bankers.

 

FIG 1. Our US inflation Nowcaster and its subcomponents

 

Source: Bloomberg, LOIM as at February 2022.

 

Balancing act

Today's evidence points to the need for tighter monetary policy in the near term. But what about the medium term? If extraordinary demand has been key to the wave of inflation we are currently facing, its future prospects should also be important. Our analysis provides two explanations. 

First, our inflation Nowcaster is slowing down, with just 37% of its components rising at present compared to 77% at the end of 2020. Second, a spectrum of factors is expected to slow growth, particularly in the US. Figure 2 provides an inventory of these and quantifies the various effects on GDP growth and US consumption growth, and we describe them as follows 

• An anticipated four-to-six rate hikes in 2022 should eliminate 0.4% of US growth. 
• Negative real wage growth – wages growing slower than inflation – should cut about 0.3%. 
• The rise in commodities during 2021 should have eliminated 0.5% of that same growth. 
• Finally, a rise in the US dollar means growth should be about 2% lower than originally expected.

US growth could therefore be closer to 2% this year rather than 4%. This would mark the first step towards a (hopeful) moderation of inflation without derailing economic activity. According to our estimates, US inflation could make a soft landing at around 3% to 4% in December 2022, although inflation should remain high temporarily. However, due to the fast-changing nature of the economy, progress will likely be counted in quarters and could be enough to test market nerves.

 

FIG 2. One-year simulation of GDP and consumption growth given various economic shocks 

Source: Bloomberg, LOIM as at February 2022.

 

Simply put, inflation should moderate in the future and this requires the current shift towards tighter monetary policy, coupled with patient execution.

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