investment viewpoints

A demand shock is driving inflation, not supply bottlenecks

Demand shock drives inflation, not supply bottlenecks?
Florian Ielpo - Head of Macro, Multi Asset

Florian Ielpo

Head of Macro, Multi Asset

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we consider which side of the supply / demand equation is behind higher inflation.


Need to know

  •  US YOY CPI in December was 7%.
  • Countries which implemented strong fiscal stimulus are now experiencing a demand shock.
  • However, supply issues are now behind us and central banks can curb demand with tighter rates.


On 12 January 2022, the US YOY CPI reading of inflation in December came in at 7%. Inflation that seemed to be transient in 2021 now appears here to stay. So what is really going on? Will high inflation be temporary or more permanent? What side of the supply / demand equation is causing this 1970s-style inflation and what is the role of the Federal Reserve (Fed) in such an environment?

Chart 1 maps economists’ 2022 inflation (in excess of trend) forecasts against their growth forecasts by country. The economies expected to grow faster than usual are also the economies that are expected to post inflation numbers above their historical mean. Through these forecasts, economists suggest that 2022 inflation should reflect stronger and more persistent growth than usual. However, inflation should also be heterogenous globally. Indeed, strong inflation looks to be more persistent in the Anglo-Saxon world whereas Japan, Switzerland and China should have tamer numbers. So what is the reason behind this?


Chart 1. 2022 inflation in excess of trend versus growth forecastsMulti-Asset-simply-put-Growth forecast-01.svg

Source: Bloomberg, LOIM as at January 2022.


Chart 2 maps economists’ 2022 inflation (in excess of trend) forecasts against past fiscal stimulus (measured by the deficit to GDP ratio between 2020 and 2021) by country. For both the USA and UK, the deficit is around 25% and they are expected to experience higher than average inflation in 2022. The Eurozone and China’s deficits of 15% should result in slightly higher than average inflation but within reasonable bounds. Whereas Switzerland only posted a 5% fiscal deficit during 2020 and 2021 and consequently trend inflation levels are expected. Now, what do those higher fiscal deficits actually mean in relation to inflation?


Chart 2. 2022 inflation in excess of trend versus past fiscal stimulation

Multi-Asset-simply-put-Fiscal stimulus-01.svg

Source: Bloomberg, LOIM as at January 2022.


High fiscal deficits actually suggest the higher inflation being experienced by these countries is driven by a demand rather than a supply shock. In the hope of curbing the pandemic’s negative economic effects, these countries overshot their fiscal stimulus and caused a demand surplus. This is not to be confused with the dovish monetary policies of the past two years. Granted, supply issues contributed to inflation at the beginning. However, if you take into consideration the fact that Los Angeles’s port processed more containers than ever in 2021 we believe supply chains are not the main inflation driver.

In our view, we are actually facing a demand shock within a higher-than-average growth environment. Central banks are therefore honouring their mandate by letting long-term rates reach higher levels in line with a strong macroeconomic backdrop. However, now is the time for central banks to adjust policy to cushion this demand.


Simply put, inflation is the consequence of excessive demand caused by extreme fiscal spending, not by disruption to the global production chain.


Nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for World growth, World inflation surprises and World monetary policy surprises are designed to keep track of the latest macro drivers making markets tick.

These indicators currently point to:

  • Solid growth worldwide, with stronger momentum in the Eurozone, while China lags.
  • Inflation surprises are more likely to be positive but could also lose momentum across the three zones.
  • Monetary policy is set to remain on the hawkish side, except in China.


World growth nowcaster

Multi-Asset-simply-put-Growth nowcaster-01.svg

World inflation nowcaster

Multi-Asset-simply-put-Inflation nowcaster-01.svg

World monetary policy nowcaster

Multi-Asset-simply-put-Policy nowcaster-01.svg

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy). Its diffusion index is computed as the percentage of increasing data within the data composing the nowcasting indicator. It varies from 0% (all decreasing) to 100% (all increasing) and is meant as a direction indicator.


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