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Inflation levels exceeding recent trends

By Andre Severino (pictured), Global Head of Fixed Income at Nikko Asset Management

Inflation levels exceeding recent trends

After many years of trying to stimulate inflation, central banks are now facing inflation levels that are far exceeding recent trends. In May, eurozone inflation rose to 2% and in the US core inflation reached 3.8% (almost a 30-year high). The question central banks now face is if these above target inflationary pressures will take hold and persist, or if they are transitory and being caused by temporary factors as the global economy restarts and adjusts back to firing on all cylinders again. How inflation evolves may be a somewhat different story in each country. However, through globalisation companies have the ability to transfer higher prices or seek lower price inputs around the world more efficiently which on balance has acted as a price stabiliser over recent years. In the near term this process may be temporarily disturbed because of economic disruption from the pandemic and allow inflation to spread globally. However, the process of companies transferring higher prices or seeking lower price inputs around the world should return as countries reopen and again act as a force against higher prices.

In 2020 the Federal Reserve (Fed) announced a major policy shift to its strategy of delivering price stability and moved to an average inflation target regime from a specific 2% CPI target. In hindsight the timing was genius, or perhaps the Fed even had foresight about what was going to unfold in 2021. This new structure has allowed the Fed to keep monetary policy and financial conditions super easy in the US amid what would have been alarmingly high inflation prints under their previous policy. Understanding how the Fed looks at inflation is also important in understanding what the future path for interest rates may look like.

Factors the Fed considers in forecasting inflation

In forecasting inflation, the Fed considers three important factors in its analysis. The first is inflation expectations. If inflation becomes imbedded in an economy and in people’s price expectations, it can be extremely difficult to contain. The Fed looks at many different surveys to try and gauge if this is occurring and the five-year Forward Inflation Expectation Rate is one of them. By this measure, expectations of higher inflation have been largely contained; the index has risen to levels seen last in 2018 but below the average over the last 20 years.

A second important factor the Fed looks at is promoting maximum employment and more specifically, doing so within current wage conditions. The state of the labour market and the possibility of sustained wage pressure to occur can be a major contributor to inflation and therefore something the Fed weighs in its inflation outlook. We have seen some wage pressure in the US; however, here too are shutdown-related factors that gives the Fed comfort that the phenomenon may be temporary. With an unemployment rate close to 6% compared to the pre-pandemic level of 3.6%, there is still much slack in the labour market and this should act to contain overall wage pressures in the near term. The special unemployment benefits are set to expire in September and this will likely add supply to the labour market hungry for workers to return.

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