How US inflation became entrenched in the system
Economists and the Fed alike failed to anticipate how broad based and persistent inflationary pressures would become.
Figures for US consumer price inflation in April will be released on Wednesday (11 May). They are expected to show the headline rate peaked in March. However, with inflation remaining at its highest levels for more than 30 years, investors are asking what it will take to bring it down.
Economists have certainly been caught out by the acceleration in prices having dismissed the pick-up as “transitory” when it started in early 2021. The rise in inflation is now looking more permanent and when questioned about whether it was still “transitory” the chair of the US Federal Reserve (Fed) Jerome Powell said “it is probably a good time to retire that word”.
So is it time to be more worried about inflation and does this make a recession more likely?
In this analysis we first look at the factors which have driven the current overshoot in inflation and then ask what would be needed to bring it down. Commodity prices have clearly played a major role in the inflation problem. While higher oil and food prices have grabbed the headlines, the issue goes deeper thus increasing the challenge for central banks to achieve a soft landing.
The inflation overshoot - the war in Ukraine is not the whole story
Looking back at our forecasts for the US we did see inflation picking up back in March 2021. However, the acceleration was expected to be modest with growth in the consumer prices index (CPI) rising to 2% year-on-year (y/y) in 2022 from a rate of 1.2% y/y at the time.
Annual core inflation (CPI excluding food and energy) was expected to pick-up from 1.6% to 1.9%. Others, including the Fed had similar projections.
One year on we now see US CPI inflation averaging at least 5.6% this year, an overshoot of 3.6 percentage points (pp). Rising commodity prices have played their part with the oil price now expected to average $95 a barrel in 2022 (some $40 higher than anticipated a year ago).
Food prices are also considerably higher. However, with core inflation at 4.7% y/y other prices are running significantly higher than expected.
Some blame can be placed on the war in Ukraine as the world economy faces the prospect of losing some 12% of its oil supply and a potentially larger loss of grain and wheat. Russia and Ukraine account for about one third of global supply.
However, food and energy accounts for just under one pp of the overshoot, or just over a quarter. The rest is outside of commodities and in the core.
Unbalanced recovery has stretched supply of goods and labour
Normally such an overshoot on core, often known as underlying inflation, can be attributed to a stronger than expected economy.
However, we had forecast a robust rebound in real GDP in the US. In fact, our expectations on growth are now slightly lower than a year ago. The trade-off between growth and inflation has been much worse than expected.
Underlying this are the well known supply side problems which we have highlighted before. The unbalanced nature of the recovery from Covid has skewed demand towards goods as restrictions have limited spending on services.
Supply chains have been stretched to breaking point resulting in bottlenecks, longer delivery times and higher prices. The war in Ukraine has only exacerbated this by disrupting supply chains in industries such as the European automotive sector, as well as bringing shortages in energy, food and metals such as nickel and palladium.
China’s zero Covid policy is blocking up ports
Covid is also continuing to play a role with the recent lock downs in China creating congestion at key ports such as Shanghai. The congestion score at China’s ports, which takes account of size and nature of cargoes, has picked up sharply this year.
It is now approaching the levels seen in 2021 when the world economy re-opened and demand surged (see chart, below). Bottlenecks and delivery times are likely to get worse for a period as a result.
In the labour market a booming goods sector has drawn workers away from services, resulting in bars, restaurants and hotels finding it difficult to recruit. The fall in immigration and labour mobility has exacerbated this problem in economies like the UK which have traditionally drawn workers in during periods of high demand.
The speed of the upswing has also played a role as it clearly caught firms off guard. The way that demand has been skewed toward one sector underpins the deterioration in the trade-off between growth and inflation. The net result has been that the world economy has run into capacity constraints for both labour and goods supply at an earlier stage than in previous cycles.
As a result the return to normal looks like taking longer than previously expected as supply constraints in commodities, ports and the labour market are yet to be resolved. Although headline inflation is peaking and will decline in coming months, core inflation is likely to be stickier.
An insight into this issue is provided by the Federal Reserve Bank of Atlanta’s “sticky” price inflation measure. The measure breaks price changes down by the frequency with which firms adjust their price lists. Commodity related prices are flexible and tend to bounce around frequently so can reverse quite rapidly.
By contrast, stickier prices such as rent and housing move more slowly. Flexible prices are currently at new highs, but note how sticky prices are also at their highest levels since the late 1980s (see chart, below).
Can a “soft landing” be achieved?
Despite doubts that they would not be fully focussed on bringing inflation down, central banks have signalled that they are committed to restoring price stability.
Amongst many comments from central bankers, Fed vice chair elect Lael Brainard, often seen as a dove, said “ inflation is very high, getting it down is the top priority”.
The Fed may have been slow in starting to tighten, but having achieved lift off the US central bank has signalled a string of rate increases alongside a reduction in its balance sheet through quantitative tightening. We expect the central bank to raise the targeted federal funds rate at every meeting this year following on from May’s 50 basis point hike to a range of 0.75% to 1%.
So can the Fed can bring inflation down without causing a recession – i.e. deliver the so-called soft landing? Essentially the central bank has to restore the balance between supply and demand such that there is sufficient slack in the economy to ease wage and price pressures.
To achieve a soft landing this has to be done gradually with the growth rate slowing below trend rather than crashing into recession with output falling and unemployment rising rapidly.
However, this is easier said than done.
Past experience shows the recessions of the 1980s and 1990s followed a similar pick up in inflation to that being experienced today. While there was much talk of achieving a soft landing during these periods, this was not to be.
There are three reasons why the odds on a recession are high at present.
First, inflation is becoming entrenched judging from the above analysis. Inflation is high and broad based whilst the labour market is tight. The rise in sticky prices is a particular concern as by their nature they move more slowly and take longer to come down.
This would allow more time for second round effects to develop where wages follow prices higher leading to a further round of price hikes.
As a result the task for central banks of bringing price rises back to target is made harder: monetary policy needs to tighten by more to bring demand into line with supply. In this environment a recession may actually be necessary to bring inflation down.
Second, monetary policy is a blunt tool. Milton Friedman’s theories have informed the monetary policies credited with taming inflation for most of the past four decades.
He said, however, that monetary policy acts with long and variable lags. Confidence effects also play a role. Fears of recession can become self full filling for example, resulting in cut backs in spending.
Central bank models give policymakers an indication of how long those lags are, but they are not precise. Judging how tight policy needs to be is difficult and the temptation is to keep raising rates until something breaks. This was very much the pattern in the 1980s and 1990s.
Third, that policy judgement is made more complex today by what is happening elsewhere.
- Monetary policy is tightening or set to tighten around the world in response to inflation, not just in the US. Global trade and external demand will be weaker as a result.
- Activity in Europe is significantly affected by the war in Ukraine and ongoing efforts to embargo Russian energy.
- The rise in commodity prices acts as a tax on consumption, reducing real incomes and spending around the world.
- China is not tightening monetary policy, but the zero Covid policy is hammering the economy.
- Finally, fiscal policy is going into reverse after the massive support during the Covid lockdowns.
So the task of achieving a soft landing seems particularly challenging at present. Interest rates will still rise as they are starting from low levels – below the “equilibrium” rate.
When an economy is at full capacity this is the rate required in order to avoid either overstimulation (and possibly undue inflationary pressures) or under-stimulation (possibly resulting in economic contraction and the risk of deflation).
We are looking for a further five consecutive hikes in rates with the fed funds rate peaking at 2.5 – 2.75% at year end. Some would see this rate as being consistent with a neutral central bank policy.
Given the current headwinds, however, it could end up being tight enough to cause the economy in the US to roll over. Inflation will come under control, but the price could well be a recession.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.