US inflation updates
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The financial markets believe in goldilocks. Having become increasingly concerned about inflationary pressures in the first five months of the year, they now agree that price hikes in the US and other advanced economies will not be too hot or too cold in the years to come.
The yield differential between nominal US government bonds and inflation-linked bonds has leveled off at just over 2 percent for the next 10 years. As Goldilocks would say, this is “spot on” and allows a stressed economy to sustain robust employment growth and a gradual normalization of monetary policy.
But reality is more chaotic than fairy tales. In the second quarter, prices rose at rates not seen in decades. In the US, core annualized inflation rose to 8.1 percent, its highest quarterly level since 1982. Obsessed with Germany, annualized inflation rose the fastest since the post-reunification boom in the early 1990s.
Central bankers insist there is little to worry about. Higher inflation was “temporary,” adding that monetary stimulus was still needed to enable a strong recovery from the coronavirus crisis. They see the risks of tightening policies too early, leaving economies too cold, as worse than the risks of ending things a little too late.
For Japan and the euro zone, their assessment appears to be justified, as both economies have been plagued by persistently low inflation over the past decade.
In general, the consensus among policy makers is also based on some solid evidence of temporary problems in the world economy. A significant portion of the recent price hike can be attributed to bottlenecks in global supply chains, especially for semiconductors. This rise in the prices of imported goods and domestically manufactured products will bring new investment in manufacturing equipment and ultimately its own healing. The increasing spread of the Delta variant of Covid-19 is already dampening the recovery in household spending.
But the more general case of inflation under control does not have a similar solid foundation in the US and UK, and it is important to understand the often implicit assumptions that underpin the assumption that inflation will move in the quarters ahead behaves significantly better.
Both countries are known to have had aggressive fiscal policies after the pandemic began to compensate businesses and people for their inability to work. For 2021, the IMF expects a US budget deficit of 13.3 percent of gross domestic product, closely followed by Great Britain with 11.7 percent, both of which are significantly more generous than the euro zone with 7.9 percent. Combined with the Covid-19 restrictions, this high level of fiscal support has resulted in higher “surpluses” than in most European countries, according to the IMF.
Excessive savings are generally not dangerous, especially since US and UK consumers are typically criticized for spending too quickly. However, it does mean that there is a risk of private spending spiking as the prevalence of the virus falls. Reassuring predictions depend on the officials being correct, that the tax authorities have calibrated support almost perfectly. As the IMF says of its own predictions, “The forecast assumes a smooth transition from exceptional political support to private sector growth with a gradual reduction in excess savings.”
The fund said more money had accumulated in countries with traditionally low savings rates, showing households there that they were likely to rebuild their finances. But the opposite conclusion – that UK and US households with spare cash traditionally spend it – is more plausible.
Labor markets are a second area of concern for inflation on both sides of the Atlantic. The Bank of England revised its forecast last week, saying that some “modest” rate hikes would be needed over the next three years as they were no more about spikes in unemployment than a smooth influx of people into jobs. In the US, labor market data also shows record levels of job vacancies and layoffs, suggesting it is extremely scarce despite high unemployment.
Neither the US nor the UK is based on wage growth, but suggests that high inflation will persist.
These significant supply-demand balance risks come at a time when China’s aging workforce suggests it will no longer be the force of global deflation as it once was, and the retirement of the great baby boomer generation is The balance will gradually shift further towards consumption in the advanced economies.
None of this suggests that we are headed for the 1970s wage and price spiral, but it points to a future where we must be more concerned about inflation than we have in recent years.
Errors are likely and should be expected. The fact that financial markets expect perfect judgment from the authorities is in itself a cause for concern.