Richard Coghlan and Chris Faulkner-MacDonagh are portfolio managers in T. Rowe Price’s global multi-asset division in Tokyo and Baltimore.
Inflation fears have sparked a great debate in the markets, especially with the recent announcement that the Basic Personal Consumption Expenditure Index prices – the Federal Reserve’s preferred measure of inflation to eliminate prices food and energy volatiles – rose 3.1% more than expected in April. over the same period in 2020.
Yet the prevailing view is that this current surge in inflation is entirely transient, due to low inflation before COVID-19, a temporary rise in energy prices and the resulting temporary dislocation. the simultaneous opening of so many sectors. This point of view is understandable. Historically, in the aftermath of recessions, especially as deep as that caused by COVID, inflation remains subdued.
However, it should be remembered that this was not a classic end-of-cycle recession. On the contrary, the market is most likely missing the coming magnitude of the cyclical price rise and is not prepared – and has not yet integrated – for a cyclical inflationary shock. Unexpected inflation is a risk for many investors who may have underinvested in real assets and other inflation sensitive assets.
The first reason for concern is that the starting conditions for inflation are quite strong, especially in a context of tight supply. Instead of sharp declines like in other recessions, headline inflation in the United States has declined only modestly in 2020, and general measures of price pressures actually increased over the year. Indeed, since the fourth quarter of 2020, commodity prices have jumped 30% or more. As a result, sequential inflation could now increase significantly.
The shift to online shopping, working from home and other social changes during COVID-19 also bankrupted businesses, reducing their overall capacity. At the same time, there is an unusual cyclical shortage of inventory in many sectors of the US economy, which we see play in daily headlines as companies attempt to fill orders from their customers.
As demand recovers, the associated replenishment could boost U.S. economic growth by up to 6% per quarter over several quarters, likely bringing GDP back to its pre-crisis trending level faster than many believe. forecast and closing the economic gap due to COVID-19.
The second cause for concern is a rapid recovery in US labor markets, which are tightening at a historically rapid pace. As the economy continues to recover, businesses are struggling to fill positions and by all accounts the current unemployment rate of 6.1% is low.
Typically, it takes two to four years after the end of a recession to reach current levels of unemployment; however, in 2020 it only took eight months. While the strong recovery helps explain the tightening of labor markets, these trends are also occurring against a backdrop of an aging population and the slowest growth in the working-age population for 70 years.
It is also likely that the downward pressure on wages from high unemployment will be less than in the years 2000 and 2010. During this period, many blue-collar workers were forced to take lower-paying jobs. in the service sector, competing with workers already in those industries and driving down wages.
After the shock of the coronavirus, on the other hand, manufacturing employment quickly returned to more than 95% of its pre-crisis level. So there are a smaller number of unemployed blue collar workers left to work in the service sector, leading companies to scramble to hire workers.
Third, the commodities sector has also seen weak investment in recent years, suggesting that supply conditions in these important upstream industries may tighten further in 2021 as demand increases. In the mining sector, for example, there is little evidence that the recent surge in iron ore prices is causing a backlash in capital spending.
Likewise, current oil consumption remains around 2 million barrels per day above production, but drillers are only slowly bringing rigs back to service. Commodity prices therefore surged unsurprisingly, as rising commodity costs are likely to fuel inflationary pressures in the months to come.
Fourth, global capacity is also tighter than in the mid-2000s, in part due to repeated rounds of Chinese supply reductions that leave Chinese producers with less standby plant capacity. In addition, a growing amount of additional investment in China today will serve depreciation rather than new new production capacity. As a result, China may become less of a source of global deflationary pressures than in the past.
Finally, low-income and middle-class Americans are more likely to increase their spending with the signing of the recent American Rescue Plan Act, which will reduce the downturn in the labor market even more quickly. At the same time, Chinese demand, especially for infrastructure and housing, and growth are also expected to remain resilient in 2021, further reducing the risk of deflationary pressure.
Conditions like this convince us that inflation will accelerate in 2021. Yet there are compelling arguments against our outlook.
The coronavirus could well return to weigh on economic activity, especially in light of the new variants and their impact on the effectiveness of vaccines. Another factor is that, as there are important structural forces behind the current low inflation environment, it is true that globalization, productivity improvements and technology are not going away anytime soon.
China’s goal of tightening credit conditions also threatens to dampen global inflation, as authorities appear to be prioritizing their deleveraging campaign and showing increased willingness to allow defaults – even though both come at the cost of a more moderate recovery. Finally, there is every chance that inflation will be tempered if the dollar appreciates at the expense of a booming economy.