Calling the inflation game

Over the past decade at least, the digital revolution, among other factors, has pushed prices down across an ever-expanding universe, heralding the dramatic fall in technology such as televisions and computers and cheaper goods via online shopping.

But, in the aftermath of the Covid-19 pandemic, that long wave came to a crashing halt. Consumer prices have been rising sharply for the first time in years, leaving policymakers facing a stark question: is the resulting pick-up in inflation transitory, or are higher prices here to stay?

The answer has huge implications for monetary policy across the developed world, leaving economists at the US Federal Reserve and other leading central banks in a guessing game on interest rates that could affect economic growth for years to come.

Arend Kapteyn, Global Head of Economics and Strategy Research at UBS, argues that what makes the economist’s job harder is that much of the recent rise in prices has taken place in goods, which normally carry much less weight in central bank inflation modelling than other factors.

“You are seeing this huge overshoot in a part of the consumer price index basket but you don’t really know how it’s supposed to behave,” says Kapteyn. “You end up with very smart people on both sides of the argument having completely different inflation forecasts.”

One driver is that the pandemic triggered a huge spending switch away from services towards goods, as consumers, starved of restaurant and entertainment offerings, and fearful of leaving their homes and public transportation, diverted disposable income towards online shopping and automobiles.

Kapteyn, who sat on a panel called “Monetary Policy: Limits, What Limits?” at the recent UBS European Conference, argues that this switch occurred everywhere, but was particularly pronounced in the US, thanks to the government’s fiscal stimulus approach, which put cash in people’s pockets. In Europe, by contrast, authorities’ preference for furlough schemes left huge swaths of the workforce on reduced income.

“The US benefits were meant to heal the service sector but because the pay-outs happened before vaccines had been rolled out, the money went on goods,” he says. According to UBS, spending on core goods, which was between 21 per cent and 22 per cent of total consumer spending prior to the pandemic, reached 26 per cent in March 2021.

At the same time, a series of bottlenecks in the global supply chain led to severe shortages in goods, which compounded the inflationary effect of heightened consumer demand. One example is semi-conductors, where a scarcity of computer chips during the pandemic led to a sharp drop in vehicle production – and a consequent increase in used-car prices. Another bottleneck developed, not only in shipping, but also in port infrastructure, and lorries to transport goods to consumers.

Alan Detmeister, Senior Economist at UBS, who moderated a panel at the recent UBS European Conference entitled “Concerning Inflation: Under-hyped or Over-appreciated?’ believes that rents, which have skyrocketed on the back of excess demand for properties with much more space, have added to the goods-supply inflation. “People suddenly found themselves stuck at home with noisy kids; if you’re trying to get something done, it’s pretty impossible,” he says.

Since January, the national median rent in the US has surged by 16.4 per cent, according to the country’s Apartment List National Rent Report. That compares with an average January to October increase during each of the three years prior to the pandemic of just 3.2 per cent.

Yet for all the pressures and uncertainty, UBS remains firmly of the belief that today’s inflationary pressures will prove transitory. In Europe, a January 2021 increase in value added tax (VAT) in Germany, and a new German carbon-dioxide pricing scheme, contributed to inflationary pressures over the year. But both of these are set to drop out of inflation calculations in 2022, lowering pressure on headline inflation.

European authorities have also moved to shield consumers from a continuing rise in energy prices. In Spain, the government has announced temporary tax cuts, whilst France has declared a freeze on gas and electricity prices next year.

As for supply pressures, Anna Titareva, European Economist at UBS, says these will prove temporary as global production increases. “Given the temporary nature of energy prices and supply pressures, we should see inflation easing when we head into 2022,” she says.

UBS expects eurozone headline inflation to peak at around 4.3 per cent in November, falling back to around 3 per cent in January 2022 and ending the year at around 1.2 per cent, well below the ECB’s 2 per cent target. In the UK, headline inflation should reach 4.6 per cent in early 2022 before starting to fall.

In the US, UBS expects ongoing pressures to push headline CPI inflation to a peak of just over 7 per cent in early 2022. Critically, it also expects a subsequent substantial fall to just 1.4 per cent headline inflation by December 2022 to begin in time for the Federal Reserve to avoid having to raise interest rates.

Many of those expectations are predicated on consumers switching back to spending on services, which would take the pressure off goods. Yet risks remain. One is that the virus persists, which would slow or stop that all-important return to spending on services. Another is that supply bottlenecks do not get resolved as quickly as expected – a phenomenon that is already playing out in Europe.

Kapteyn accepts that making predictions on supply chain bottlenecks carries risk. But he also insists that such disruptions are by nature transitory – a fact that ultimately points to today’s inflation looking temporary, rather than structural.“ If you want to make the argument for a permanent rise in inflation you have to point to something that existed pre-pandemic that is somehow no longer there,” he says. “And I can’t think of what that is.”