Focus
August 21, 2020 | 13:44
The Inflation Tug-O-War
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
The Inflation Tug-O-War |
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The inflation story has long been characterized by downside risk from the long-term disinflationary pressure imposed by various global factors. Early in the pandemic, the conventional wisdom was that a deep recession would pry open the output gap, and apply even further downward pressure on inflation. But, that wisdom is now being challenged by some acute supply shortages and a much stronger-than-expected U.S. inflation report in July. After all, if one considers an historic global pandemic to be a negative supply shock for the economy, the textbook outcome would be lower output and higher inflation. We believe there will be some pockets of short-term upward price pressure, and that economic destruction may well cut potential output more than most think. But, the bigger picture still remains that longer-term secular forces holding inflation back will persist and ultimately win out in North America. |
Over the past 30 years, global central banks have almost all turned to inflation targeting as their main policy driver. In that time, the thinking around inflation has evolved from watching money supply initially (and pre-inflation targeting) to focusing on the output gap. Briefly, today’s thinking is that, when the economy is running below capacity, inflation falls; and, when the economy is running above capacity, inflation accelerates. Then there’s that happy medium where inflation runs around target (usually 2%). Accordingly, as noted above, on the surface the cratering in economic activity due to the pandemic opens up a wide output gap and puts downward pressure on prices (Chart 1). However, this isn’t a normal recession. Indeed, the longer the pandemic drags on, the deeper the economic scarring is expected to be. The impact on small business (think restaurants, retail) has yet to be fully tallied, but many have already closed their doors for good, and many more are teetering on the brink. Lost businesses mean lost capacity, in turn cutting potential growth, suggesting that the output gap may not be as wide as it appears on the surface. While GDP remains well below pre-COVID levels for now, inflation could return sooner than expected if there is indeed less capacity available. Staying with central banks, one notable shift from past cycles is that there's a distinct appetite to let inflation run a bit hot after a long period below target. Indeed, after the financial crisis, inflation was slow to perk up, but once it started to accelerate in late 2015 (at least in the U.S.) the Fed began to tighten policy even with core PCE inflation well below the 2% target. This time around, the Fed appears to be leaning toward average inflation targeting, suggesting inflation will be allowed to run above target for a potentially lengthy period. Look for global central banks to follow that general template suggesting policy rates will remain near-zero for a long time. Recent data have delivered at least one point to highlight the potential for higher inflation, as U.S. core CPI posted its biggest monthly increase since 1991 in July. But, keep in mind that core inflation was still up a modest 1.6% y/y, and much of the pop reflected the unwinding of deep price declines during the height of the pandemic. For example, auto insurance premiums posted a record increase after earlier deep cuts, and airfares have begun to rebound, but are still well below pre-COVID levels, though some anecdotes now suggest otherwise (Chart 2). Other sectors like autos and video services seem to be more fundamentally driven by lean inventories or surging demand. In Canada, however, there’s a distinct lack of inflation, with CPI ex-food & energy up just 0.5% y/y in July, a 25-year low (Chart 3). There’s not an obvious driver of this gap—medical care service inflation has jumped in the U.S.; hotel prices have collapsed harder in Canada. It’s becoming evident that there’s a battle starting between the disinflationary impact of weak demand and struggling businesses looking to survive, and the inflationary impact of capacity constraints, shortages and PPE costs. On the latter, lumber and some construction products are facing both a positive demand shock (renovation activity has jumped) and supply shortages as some producers cut back output early in the pandemic, wrongly anticipating lower demand. Some raw lumber prices, for example, have tripled from their April low (Chart 4). Meantime, anecdotes suggest that skilled trades are severely backlogged across many major cities, which should push up repair/renovation costs. Elsewhere, restaurants forced to operate with stern capacity constraints could be forced to lift prices to make up at least part of the difference (commercial rents will also likely come down). There is some evidence in both U.S. and Canadian CPI that restaurant inflation is indeed turning up. Interestingly, the market has pulled U.S. 5-year forward inflation expectations back up to 1.8%, in-line with pre-COVID levels (Chart 5). Considering the massive hole carved into the economy, this is a statement in itself that there could indeed be some pockets of upward pressure in the near term. |
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Longer-term, there continues to be strong disinflationary forces at work. Demographics and technology are the most notable. The aging of the developed world is no secret, but the impact isn’t always easy to extricate from the cyclical gyrations of the economy. An aging population impacts inflation on the demand and supply side. On the demand side: As people head toward retirement, they move beyond their prime consumption years. On the supply side: An increasing share of the population in retirement means fewer workers. Meantime, technological advances continue to lower the cost of doing business. Telecommuting has the potential to open up a new pool of workers for many businesses, keeping a lid on wage inflation. And, goods production is increasingly done by machines rather than people, keeping marginal costs contained. In many ways, the pandemic has pulled forward slower-developing secular trends, and it might be doing the same for these inflation-dampening forces. The Bottom Line: The near-term inflation picture will likely be characterized by broad downward pressure caused by economic slack, with scattered pockets of (sometimes acute) upward pressure resulting from capacity constraints or supply shortages. Business destruction could reduce the size of the output gap, thereby keeping a floor under inflation, but longer-term disinflationary forces will form the ceiling. All told, the inflation data will be far more interesting than in the recent past, but the near-term implications for policy at this point might be limited--central banks will remain highly accomodative. |