Part 1. Short-term Inflation and Risk Factors
Although inflation (defined in nominal terms as an increase in the general price level) is increasing. in the US, UK, and the Euro area, following a long period of deflation and a pandemic slowdown in economic growth. Yet it is too early to claim that the current inflation is to stay permanently. A market survey of economists predicts a first move of the Fed funds rate in the United States to take place in the second half of 2023. However, some forecast it to happen earlier, in 2022. Meanwhile, investors interrogate closely any news coming from the Federal Reserve to be able to make an informed guess of the first increase in the target interest rates. In this transitional period, obviously, the central bank’s response is of vital importance, not only to market investors, but also to the rest of us.
Inflation may also be defined in terms of the growth of nominal income exceeding the growth of real output. The issue for economic forecasters is then to model the determinants of each of these variables, including the dynamics of any mutual interactions.
Inflationary influences come from a variety of risk factors, such as the impacts of various constraints on the growth of the main variables. These are supply-chain disruptions, immediate labour shortages and wage pressure, as well as historically high rates of resource utilisation. Other factors – accelerating short-term supply difficulties – can further increase inflation dynamics [1]. Markets are guessing right now, and moreover, the central banks are uncertain too.
In the minutes of the Federal Reserve from the 7th July, and a report submitted to the Senate Committee on Banking, Housing and Urban Affairs, and the House Committee on Financial Services from the 9th July one can conclude that despite the expectations of inflation subsiding, the wording in these reports demonstrates how the direction of the current inflation can go either way. With this uncertainty in mind the authors will analyse current international developments, mainly in the US, UK and EU, and risk factors that may impact the current levels of inflation. In Part I of this Op-ed, the statistical data will be provided and analysed, and then in Part II – the inflationary pressures will be discussed, especially in relation to some of the issues raised in the US Congressional debates.
Statistical Data and Analysis
If one looks at the statistical data of the US, UK, the EU, and compares recent trends, picking-up of prices has been observed in the advanced countries to a great extent (see Table 1).
12-month change measures of inflation – either using CPI in the US and UK, or HICP in Europe – were boosted by the base effects of the drop-in prices from the spring of 2020 rolling out of the calculation, and the surge in consumer demand as economies began to reopen gradually in March – April. The core inflation, excluding energy and food prices, is more modest. Already released inflation rates for June are also lower than the ones in April – May, which might be a brief flip during this summer seasonal work.
On the other side, in the US total payroll employment refilled 2/3rds of the job losses seen at the onset of the pandemic, while employment in the leisure and hospitality sector as well as education industry (both private and public education) bounced back by less. The unemployment rate is stabilized at 5.8%, which is lower than the one in April, but still far away from the pre-pandemic levels of around 3.5%. However, this pandemic brought unusually large and new challenges to the US labour market as some workers lost their jobs, others left the jobs temporarily or completely left the workforce. Employment changes did happen uniformly across sectors, as some sectors lost a proportion of their employees and other sectors had to move their staff to homebased environment [2]. With this fragmentation of the labour market conditions by sector, achieving maximum employment demands great efforts from the FRB to monitor and assess correctly before they could decide whether to taper quantitative easing or not.
In the UK, the unemployment rate fell down to 4.7% in April and 4.8% in May as companies began to search for new staff (see Table 2). There were 862,000 job vacancies in April to June 2021, which is 77,500 above its pre-pandemic level in January to March 2020. The redundancy rate decreased and had returned to its pre-pandemic level. It is expected from this autumn the unemployment rate to stabilize at 5.5% throughout the winter, though the ending of the furlough scheme in September may increase that rate. Again, there is uncertainty.
In Europe, the unemployment rate was 7.4 in April and 7.3 in May as underemployed part-time workers made up about 3% (see Fig. 1). Overall, Germany and Poland had the lowest rates of 3.7% and 3% of the labour force in May while Greece and Spain suffered the worst unemployment rates of 16.3% and 15.6% respectively, some of this problem linked to the high dependency of these countries on tourism. Comparatively, on average, the unemployment in the Eurozone countries was the highest in April and May among all countries in our analysis. The youth unemployment contributed to the higher overall unemployment rate, with nearly 3 million young people (under 25) could not find a job. In March 2021, the youth unemployment rate was 17.1%, which illustrates that the pandemic has not changed the structural weaknesses of the EU labour market. In summary, the recovery has begun, but there is a significant labour market slack in Europe, which makes the ECB more confident with the claims that the current pick-up of prices is transitory.
Figure 1: Employment rate and labour market conditions
The GDP growth in the US has increased significantly and is moving faster in the second quarter than Q1 2021 according to the Fed’s reports. The UK and the EU experienced contractions in the first quarter (see Table 3). In the UK, a more complex set of factors influenced the GDP huge slowdown as the country processed the Brexit agreement and suffered strict lockdowns in early 2021, so the Q2 GDP growth might be a bit more optimistic. In Europe, Ireland (+7.8%) and Croatia (+5.8%) recorded the sharpest increases of GDP while declines were observed in Portugal (-3.3%), Slovakia (-2%), followed by Germany (-1.8%) and Latvia (-1.7%).
Based on hours worked, the productivity compared to Q1 2020 increased by 2% for the euro area and to 1.1% for the EU, so there is potential for boosting the productivity further in the Member-states that could open the economies entirely. In other states such as Spain, Portugal and Cyprus where the new cases of COVID-19 have been increasing recently, the opening will be delayed or may not happen this summer at all, which is a natural barrier to improving productivity. For instance, Lisbon is in a strict lockdown right now and could not welcome the usual large number of tourists to the country. Spain has 486, 939 active cases (22nd July 2021) and increases the restrictive measures on the territory. Similarly, Cyprus has a large pick-up in the daily cases [3].
Overall, the US economic recovery is moving ahead of the UK and EU recoveries, with good signs of strengthening gradually all sectors in the last three months, which likely to be, at least partly, a result of the $trillion stimulus packages and a subsequent surge in consumption [4]. However, all statistical data point to a range of free capacity still available in these economies, which may dampen any sustained surge in inflation. We can now consider these and other factors which may lead to a resumption of a growth in real output, without inflationary consequences.
Part II. Medium-term Inflation and Risk Factors
Monitoring the inflationary pressure in medium-term, particularly expectations, commodity prices (especially food and energy), potential labour shortages, exchange rate impacts, and other potential supply constraints will shed light on possible medium-term risk factors.
On the upside – bottlenecks, supply-chain disruptions, shortage of labour, and historically high rates of resource utilisation were seen as potential sources of greater than expected inflationary pressures. Here comes a significant rise in inflation expectations that increases dynamics and accelerates inflation further.
On the downside – if the effects of supply constraints proved to be transitory, as most economists expect, then the inflation record from the past 25 years suggests the possibility that low underlying trend inflation and a flat Phillips curve could cause inflation to revert to relatively low levels despite a strengthening economy.
We will examine the main arguments of protagonists of the view – in the UK and in the US – that a high upside risk of the potential persistence of inflation in the medium-term. There are, of course significant economic and monetary differences in each of the two countries, especially in the size and nature of the US fiscal stimulus. Nonetheless, the broad arguments in favour of the position are similar.
Part II- Section 1: Looking at the UK, perhaps the most persuasive advocate of this view is Andy Haldane [5], until recently, chief economist at the BoE, who differs from the view of his ex-colleagues and the Bank’s Monetary Policy Committee.
Haldane’s paper is a well-balanced approach to the issue, shorn of any “party-political” advocacy, yet he still concludes, based on some key issues discussed below, that the prospect of inflationary pressures in the medium-term has a high-risk potential. His conclusion is that “we might see a sharper and more sustained rise in UK inflation than expected, potentially overshooting its target for a more sustained period, as resurgent demand bumps up against constrained supply. There are essentially five factors that Haldane adduces to justify this position.
First, Haldane argues that the Covid crisis impact on estimates of the output gap (the difference between the actual growth performance of the economy and its potential performance) are extremely uncertain, and especially in terms of unemployment currently and in the medium term. He suggests that the relative stability of inflation during the Covid period means that demand and supply have fallen by the same amount. Hence the output gap has remained at the earlier BoE estimate of a 3% peak Covid-induced gap, and that this gap may close over the next 18 months, as the BoE itself expects. This reduction in the output gap may create inflationary pressures.
The problem with this argument, as Haldane, as an economist, knows, is that estimates of output gaps by central banks, and Finance Ministries, are notoriously unreliable. Output gaps are not directly observable and have to be calculated (there are at least three methods that are used). Moreover, the historical bias in official output gap estimates has consistently been to under-estimate the gaps, that is there is always greater spare capacity than assumed [6].
Second, he uses the growth of commercial bank money (M4), currently standing at a little over 14%, though annual growth of M4 lending is more modest, at just over 4%, though above the average over the past decade. Part of this growth is because of the £70 billion Covid business loans.
Haldane suggests looking at this monetary growth as the counterpart of the excess savings in the economy. In the US, these excess savings total around $1½ trillion and in the euro-area almost $½ trillion, although these savings are unevenly distributed across household types. In the UK, the picture is much the same. Excess savings currently total around £150 billion for households and over £100 billion for companies, with the lion’s share of these savings are in highly liquid bank deposits. Haldane argues that this leaves accumulated liquid savings much higher than compared to the aftermath of the global financial crisis.
Clearly, what fraction of these savings will be spent is a key factor. The BoE assumes around 5%, Haldane argues that this is too conservative estimate.
This element of Haldane’s argument is more persuasive, yet again it depends crucially on his uncertain estimate that the 5% spend estimate is too low (he does not provide and alternative percentage).
Third, he argues that there are also national and global supply-side forces that will permit the demand side factors to translate into higher medium-term inflation. Although accepting that over the past few decades, supply-side constraints have been eased because of increased trade, automation, and working populations, Haldane argues that these factors will slow and even go into reverse.
The UK has been a particular beneficiary of demographic trends over recent years. The UK working age population has risen, on average, by over ½% per year over the past two decades. It has also experienced rising rates of labour market participation, especially among older workers and women.
Haldane suggests that the UK population may shrink by as much as 1.3 million [7] and labour market participation rates, which have been increasing, will reduce. Moreover, the share of the total UK population of working age has been falling since 2008. As the population ages and workers retire, labour-supply growth will weaken, and the bargaining power of workers and trade unions will strengthen. Perhaps sufficient to start to increase the slope of the current flat Phillips curve.
Haldane also suggests that global trade volumes collapsed by around 15% at the peak of the Covid crisis, compared to a fall in global activity of around 9% (Chart 16 in his report). The Covid crisis also saw the fracturing of some global value chains, in part as a result of countries prioritising domestic over international supply of some goods and services. If globalization falters, then its downward pressure on import prices would weaken.
All these factors, pressing downwards on prices over recent decades, are unlikely to be thrown into reverse, and hence, to validate Haldane’s proposition of increasing inflationary medium-term pressures in the UK, and perhaps elsewhere. Though there may be some retrenchment towards domestic supply chains in the UK, there is no evidence, at least yet, of any substantial movement. However, maintenance of EU suppliers may involve some upward pressure on prices. The other factors suggested by Haldane are subject to considerable uncertainty and doubt, including the potential strengthening of trade union negotiating power.
Fourth, Haldane argues that the substantial Covid fiscal policy stimulus has reduced the peak output gap from around 4% in the GFC to around 3% in the Covid situation.
This suggestion is subject to the counter argument deployed in the comment on the direct suggestion of Haldane on the estimate of the gap itself. Moreover, present political indications suggest that though there is unlikely to be a return to tight austerity post-Covid, fiscal policy will likely be prudent!
Fifth, he argues, though with nothing more than a “hunch” to back it up, that the “psychological scarring” – and hence low risk appetite following the Global Financial Crisis – will not be repeated following a similar Covid suppression of demand and supply. Rather, Haldane suggests, will Covid be followed by a high-risk appetite on behalf of consumers and businesses.
Notwithstanding the accurate observation, that psychology plays a strong part in determining economic behaviour, this “hunch” of Haldane’s, unsupported by other strong economic arguments cannot support his conclusion.
Part II Section 2: In this section we will concentrate on the UK and the US, and assume that the arguments deployed will not be dissimilar the those applicable to the EU27 and the Eurozone. There are also greater difficulties in covering the issues across varying countries with each of these latter economic entities.
Looking at the US situation – and looking at the proponents of the view of the high upside risk of inflation in the medium-term – it is worth examining in more detail the debates in the Senate Committee on Banking, Housing and Urban Affairs, and the House Committee on Financial Services from the 9thJuly [8]. Not surprisingly, the alternative view – to that of the Federal Reserve and the Biden Administration – is promulgated by the Republicans, though there are some Democrats (such as Larry Summers). Unlike Haldane’s approach therefore there is a strong partisan element in the Republican approach to assessing the risks of medium-term inflationary pressures.
The view of Powell – Chair of the Federal Reserve – in his statement was that inflation had increased notably and would be likely to remain elevated for some months, before moderating. He expected that inflation was on track to moderately exceed 2 percent for some time. The price increases had been temporarily boosted, as a result of the pandemic-related price declines from last Spring, and hence drop out of the annual assessment. In addition, strong demand in sectors where production bottlenecks or other supply constraints have limited production has led to especially rapid price increases for some goods and services, which should partially reverse as the effects of the bottlenecks unwind.
Powell indicated that the Fed will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent, while continuing to monitor as always, in assessing the appropriate stance of monetary policy, the Fed will continue to monitor the implications of incoming information for the economic outlook.
The opposing view to the one presented by Powell, was that of the Ranking Member Pat Toomey (R-Pa.) [9].
Toomey suggested that the Fed’s own forecasts suggested a GDP growth of 7% in 2021 and that the unemployment rate, at 5.9%, was already close to the past 20-year average level of 6% and predicted to fall to 4.5% by the end of 2021. Core CPI, which excludes volatile categories like food and energy, was up 4.5 percent in June -the highest reading in almost 30 years. Indeed, Toomey quoted the two-year annual change in core CPI being at a 25-year high. He added that, for the rest of the year, inflation would need to be nearly zero for the Fed’s latest projection to be proven correct.
Although these points did not necessarily invalidate the Fed’s position that the current inflation is transitory, Toomey made three other specific points suggesting the medium-term persistence of inflation:
First, that the Fed had consistently underestimated inflation over the past 12 months
Second, the Fed has announced it will continue to allow inflation to run above its 2% target level (though the Fed now has an average inflation target).
Third, that the Fed has caused the current inflation because of its recent unprecedented monetary accommodation.
Toomey further argued that the Fed’s current monetary approach seems to be based on the misguided premise that it must prioritize maximum employment over controlling inflation He suggested that when the Fed subordinates its price stability mandate to try and maximize employment, the Fed runs the risk of failing on both fronts because you need stable prices to achieve a strong economy and maximum employment. This is not a partisan argument. To avoid the charge of being partisan, he then quoted prominent Democrat economists, including President Clinton’s Treasury Secretary Larry Summers and President Obama’s CEA Chair Jason Furman, who have expressed their concerns about the risk of rising inflation (though their objections essentially related more to the Treasury fiscal policy than the Fed per se). His concern that in these circumstances why was the Fed still pursuing credit easing by buying $40 billion of mortgage-backed bonds each month.
Although one might query the combination of the massive fiscal stimulus and the continuation of the Fed’s own relaxed monetary policy, the charges made by Toomey, unlike the economic arguments suggested by Haldane, do not actually provide any underlying economic argumentation supporting medium-term inflationary pressures. There is little doubt that in the US, as in the UK and the Euro-area, the current increase in core inflation (certainly higher in the US) is likely to be associated with the emergence of the economies from the Covid pandemic (though with varying levels of uncertainty about the speed of transition). Hence, the key issue of the extent medium-term inflationary pressure is currently, in the view of the Fed, sufficiently uncertain so as to cause it to avoid any movement to alleviate the potential pressure. There is still time for the Fed to act by the end of 2021, if their monitoring suggests remedial action.
Overall Conclusions
In terms of this relatively brief economic commentary, the arguments advanced by Haldane are the ones deserving attention. Although focused principally on the UK, they have a wider relevance.
On any attempt to forecast what may happen in the medium-term, we necessarily start off from the current, short-term situation. The next stage is to identify those associated economic, monetary, and psychological factors which will allow us to extrapolate into the medium-term. Haldane specifies many, if not all of the factors and trends involved. The UK is probably the best case to investigate, as though there has been a fiscal stimulus, it is not the dominant factor that it is in the US.
There is no need to repeat the comments made on each of the five propositions advanced by Haldane to support his conclusion, namely that there is a risk that inflationary pressures may well extend into the medium-term. Haldane’s paper is a balanced exposition. However, the arguments adduced in favour of his policy stance are surrounded by considerable uncertainty, and perhaps some weaker economic arguments, based on dimly perceived trends.
Global factors, as Haldane suggests, may provide an influence in the medium-term. It is possible that that structural supply factors, influenced by climate change policies, may exert sustained pressure on oil and gas market prices in the future and, if secular upward trends become established, may raise core inflation.
However, the main conclusion we may draw from the debate is that the uncertainties are too great to draw firm conclusions. On the balance of probabilities, the subdued inflation trends, globally and nationally, experienced from the GFC onwards, and to some degree prior to that event, appear, for the time being, likely to continue.
Endnotes:
[1] Monetary Policy Report, July 9th2021, https://www.federalreserve.gov/monetarypolicy/mpr_default.htm
[2] Schweitzer M., E. Dohrman, “How the Pandemic has reshaped economic inclusion in the United States”, Economic Commentary Number 2021-14, June 2021, Federal Reserve Bank of Cleveland
[3] https://www.worldometers.info/coronavirus/
[4] Some economists argue that the US economy is overheating – one of them is Larry Summers (see Bloomberg interviews)
[5] Inflation: A Tiger by the Tail? Speech given by Andy Haldane Chief Economist and Member of the Monetary Policy Committee Online 26 February 2021
[6] M. Lloyd EP paper, 1998
[7] See O’Connor and Portes (2021). The authors themselves describe this estimate as an upper bound.
[8] Monetary Policy Report, July 9th2021, https://www.federalreserve.gov/monetarypolicy/mpr_default.htm
[9] https://www.banking.senate.gov/imo/media/doc/Toomey%20Statement%207-15-21.pdf