Many people have written about how the ‘spectre of inflation’ has returned to haunt investors. In fact, the financial markets are still remarkably sanguine, reassured by dovish comments from central banks. This was reasonable in the depths of the Covid recession. Now it looks increasingly complacent.
There has already been a sharp rise in government bond yields this year, notably in the US and Australia. But the big picture is that they remain near historic lows: 10-year yields are still below 2% in the US, below 1% in the UK, and actually negative in Germany and France.
This rise in yields that we have seen is partly due to a reassessment of the inflation outlook. Nonetheless, market expectations for inflation over the medium term are typically not much higher than when the pandemic struck. There is little sign here that investors are spooked.
This can be gauged from ‘breakeven inflation rates’, which are a measure of expected inflation derived from the differences between the yields on conventional and on inflation-indexed bonds. Even in the US, 5-year breakeven inflation rates are still only around 2.5%, and therefore still within the ‘normal’ range of 1-3%.
What’s more, central banks have signalled that they are in no hurry to raise interest rates. In particular, the US Fed has said it will tolerate a period of inflation above its long-term target of 2% after a period when actual inflation has been running persistently below this goal. The rise in 5-year inflation expectations is therefore consistent with this guidance.
There is a ‘good news’ story here too: the sell-off in bond markets also reflects growing optimism about the outlook for the real economy. The largest increases in yields have therefore been in countries where economic prospects have improved the most.
For example, the OECD has recently doubled its forecast for US GDP growth in 2021, helped by the additional fiscal stimulus planned by the Biden administration. In contrast, growth forecasts for the euro area have barely changed, reflecting the slower rollout of the vaccines in the EU.
In the meantime, though, the main risks to inflation all appear to be on the upside. Consumer price inflation has already picked up to around 2% in both the US and euro area, mainly due to the rebound in global energy prices. UK CPI inflation was just 0.4% in February but will also jump in the coming months, especially in April when Ofgem lifts its energy price cap. As Andrew Sentance has pointed out, other measures of UK inflation are already higher.
There is also plenty of evidence of further inflation pressures in the pipeline, including large increases in measures of input costs in business surveys (notably the PMIs compiled by Markit) and in official data on producer prices.
This could be shrugged off as a reflection of two temporary factors. The first is the impact of the rebound in oil prices, which already appear to be levelling out. (The prices of some industrial metals such as copper have risen further, but they have been higher in the past.)
The second is the impacts of imbalances in demand and supply caused by Covid, such as the surge in global shipping costs and a shortage of semiconductor chips. Again, these problems already appear to be easing: freight rates are starting to fall and global production of chips is bouncing back.
Nonetheless, these could simply be warnings of more price pressures to come as economies reopen fully. For now, both demand and supply are heavily constrained by the pandemic, making it unwise to read too much into the current inflation data.
Inflation doves are banking on there being plenty of spare capacity to meet surging demand as Covid restrictions are eased. Enormous amounts of public money have been spent on protecting businesses so that they are ready to open again when the lockdown is lifted. But many businesses will still face higher costs and constraints on the number of customers that they can safely serve.
The amount of slack in labour markets is especially uncertain. In the UK, there are still around 5 million people on the government’s furlough scheme – most of whom would otherwise be unemployed.
However, many surveys show that employment prospects are already improving sharply, and that consumers are now more confident about job security. The exodus of a significant (but uncertain) number of migrant workers, especially EU citizens, could also strengthen the bargaining power of those born in the UK.
Above all, as any student of economics should know, inflation is caused by too much money chasing too few goods and services. Global money growth has exploded, largely as a result of the way in which central banks have embraced quantitative easing (QE).
Unlike the period after the global financial crisis, the latest bout of QE is being accompanied by looser fiscal policy, and the banking system itself is still working well. This means that more of the additional money is readily available for businesses and consumers to spend, when they can.
In the UK, ‘broad money’ has expanded by around 15% over the past year alone. This measure is a good leading indicator of nominal GDP, suggesting that we are heading either for a period of very rapid growth in economic activity or much higher inflation – and possibly both.
To be clear, I remain relatively optimistic on growth and fairly relaxed on inflation. In the UK, I expect GDP to return to the pre-Covid levels as soon as the third quarter of this year, unemployment to peak below 6%, and the public finances to continue to recover more quickly than the OBR has been forecasting.
As for consumer prices, my best guess is that the UK will see a year or two of 3% inflation (before a return to the 2% target). This would only be about 1% higher than the average of independent forecasts for 2021 and 2022 in the latest Treasury survey. Even without China, global markets are still highly competitive, especially thanks to the growth of the digital economy.
Nonetheless, a sustained period of 3% inflation would be consistent with the Bank of England hiking official rates to 1% next year, and 10-year gilt yields rising to 2%. If I were on the MPC, I’d already have a strong bias towards tightening and would expect to vote for a first rate increase later this year.
This is still a benign scenario (except for holders of government bonds and those on fixed incomes). The combination of a stronger economic recovery and a little more inflation should more than offset the impact of rising interest rates on stock market valuations – and on the public finances. Crucially, interest rates are likely to remain low relative to both economic growth and inflation, and the debt-to-GDP ratio should still start to fall quickly within a few years.
Unfortunately, the risks to inflation are surely skewed in one direction, given the prospect of a surge in pent-up demand fuelled by money printing. If my best guess is wrong, it would probably be because inflation is higher and interest rates need to be raised further. This is something that needs watching like a hawk. As it is, I think that UK short rates are heading for 1%, 10-year gilt yields to 2%, and inflation to 3%.