Enemy No. 1: Inflation

If economists and central bankers had a “Public Enemy” category, like INTERPOL or the FBI do, inflation would undoubtedly be elected the No. 1 enemy of the people.

In the United States, consumer prices surged 1.2% in March, the biggest monthly gain since September 2005. In Europe, the annual inflation rate jumped to 7.5% in March, up from 5.9% the month before as the invasion of Ukraine by Russia sent energy and food prices soaring. In Britain, inflation is at the highest level in three decades, even as the Bank of England has already raised interest rates three times since December to their pre-pandemic level amid growing evidence that companies are responding to higher prices by raising wages. Even in Japan, which has battled low or negative inflation for decades, higher prices are reaching its shores, with one-year inflation expectations reaching 2.7%, the highest since 2014. The rest of Asia, where the region looked to escape the global increase in pricing just a few months ago, is caught up in the tsunami of price increases
across the globe. Inflation readings across the Asian region, including China, India, Indonesia, Philippines, Thailand, and South Korea, recently rose more than forecast. New Zealand recently hiked rates by the most in 22-years over price worries. Inflation is an enemy that few can escape.

How We Got Here

Economic historians of the future will debate just how the inflation cat got out of the bag. It is safe to place part of the blame on the pandemic and the quicker-than-anticipated recovery that sent prices spiraling upward. In most post-recession periods the recovery usually develops in steps, and at a slower pace than the present one. The speed of this recovery and the help provided by fiscal and monetary policy helped boost economic activity but at a price of increased inflation. Price increases are normal during early recovery periods, and usually, supply catches up and prices start to backtrack within a
reasonable amount of time. This recovery is different, however, because of the speed of the upturn and the fact that it involved a pandemic that placed stress on the labor force. The combination of strong demand, limited supply, and a lack of labor led to a formidable emergence of inflation. The law of supply and demand still holds, and there is some evidence that, on the goods side, price increases were showing signs of slowing before Russia invaded Ukraine. During the pandemic, families had to choose between going to work or staying at home; and, with schools closed, millions decided to send only one
family member back to work. The combination of sharply higher demand, limited labor, and limited response from the supply chain led to a burst of inflationary forces. Add the Ukraine war and the COVID outbreak in China, and we have a “Perfect Storm” of geopolitical events for policymakers to battle against.

Fighting Back

To fight inflation, the Federal Reserve and other central banks are moving to slow economic activity by raising rates and dialing back their qualitative easing efforts. Some members of the FMOC have even publicly admitted that they are indeed “behind the curve” in slowing what appears to some as a run-away train. Central bankers do not like to admit mistakes, so a public statement is of note. Similar to the situation in the U.S., policymakers in other countries have also been caught by persistently high inflation. The general thinking of central bankers was that price increases were expected to ease, as
economies recovered from the pandemic, but surging food and energy prices have continued to lift inflation around the world. High inflation is indeed quite widespread. Among the United States, the Euro-area, and other so-called advanced economies, 60% have annual inflation rates over 5% according to the Bank of International Settlements. It is the largest share since the 1980s and a serious problem for central banks, which typically target inflation at about 2%. In emerging economies, more than half have
inflation rates above 7%. For now, China and India are notable exceptions.

The race is now on to contain inflationary pressures. New Zealand and Canada delivered half-point increases recently and, so far, the ECB is sticking with plans to dial back stimulus this year. On the top-five list of hawkish economies is No.1-Norway, which hiked rates by 25 basis points to 0.75% on March 24 and plans to hike at a faster rate than currently planned. The Norges Bank plans eight hikes to bring rates to 2.5% by the end of 2023, three more than planned in March. No.2 on the hawkish list is New Zealand, who raised rates by 50 basis points to 1.5%, the biggest rise in two decades and the fourth in the current cycle. Its forecast is to reach 3.35% by the end of 2023. Canada comes in third, with its 50 basis point rise to 1% in March, the biggest single move in more than two decades. The BOC expects rates to hit 2.5% by year’s end. With inflation at a 30-year high, the Bank of England is under pressure to tighten policy further after the three hikes in December. Markets are certain it will raise rates by 25 basis points to 1% on May 5 and reach 2.25% by the end of 2022. If current plans are completed, the U.S. will come in fifth
on the hawkish charts. The Federal Reserve has raised rates by a quarter-point to a 0.25%-0.5% target range and has flagged a 50-point move in May. It also is discussing trimming its asset portfolio. Inflation, which hit a 40-year high at 8.5%, maybe start to peak, but will remain above the Fed’s target of 2% at least through 2023.

Looking Ahead

Future policy moves will depend on data, and there is some acknowledgment that the rise in inflation contains a large component of the fallout from the war in Ukraine. That war has had a major impact on food and energy costs that will not diminish, as long as the conflict continues. Even with central bank intervention, demand for food and energy, which collectively account for a substantial percentage of inflationary pressures, will still exist. Even if events were to move toward a peaceful resolution to the conflict, it will take time for a political solution to help the economic fallout of the war. The sanctions are
unlikely to be lifted quickly on Russia, and perhaps not at all. It does appear that the price of some commodities is stabilizing, leading to some reduction in inflationary pressures. However, a return to pre-conflict levels is unlikely for quite a period of time. Inflationary pressures will be hard to tame this time.

For the United States, inflation is at a record pace. The CPI surged 1.2% in March, the biggest monthly jump since September 2005. About 70% of March’s increase can be traced to higher energy prices following Russia's invasion of Ukraine. Prices at the pump leaped 18.3% last month on a seasonally adjusted basis, the biggest increase since June 2009 when gas prices were still under $3. The good news for the consumer is that gasoline prices have since retreated in recent weeks. However, energy is not the
only source of pain for households. Food-at-home prices jumped 1.5% in March and up 10% over the past year. The latter being the largest one-year rise in grocery prices in 41 years. Inflation also exists up the chain. U.S. producer prices increased by the most, in more than 12 years, in March. Amid strong demand for goods and services, producer prices for final demand increased 1.4% in March, the largest monthly increase since the government revamped the data series in December 2009. Goods prices jumped 2.3% in both March and February. The core index accelerated 0.9% in March, following a 0.2% advance in February.

The squeeze on households from skyrocketing prices for necessities is very real. However, underneath the surface, there are signs that pandemic-related inflation is beginning to ease. Core goods inflation fell by the most since April 2020, led by a decline in used auto prices. Core services inflation gathered steam with higher prices for airfare, lodging from home, and areas associated with reopening categories, which were anticipated to post decent price increases. This trend away from goods and toward service inflation was widely expected. Although widening lockdowns in China are a risk to a weaker trend in goods inflation, the recent data was an encouraging sign that goods inflation is finally starting to roll over.

The big question is how far and fast will the Fed go? Minutes from the Fed have indicated that interest rates are going up, and statements from officials anticipate a 50-basis-point move in both May and June. Markets anticipate upward moves reaching a total of 250-basis-points for the year, and three more moves in 2023, if necessary. In addition, a maximum of $60 billion in Treasuries and $35 billion in mortgage-backed securities are to be sold over three months, starting in May. Statements from FMOC members have all been serious in tone concerning the issue of bringing inflation down. Will they be
making a policy error? In that issue, only time will tell. The Fed will be data-driven, and only a notable drop in inflation or economic activity will cause them to pause. In an environment like this, the probability of a recession has increased, but by no means is it certain. Europe’s more extensive financial and trade ties to Russia and Ukraine make it more probable that they could face recession than the U.S. and is a big reason the ECB has not tightened policy yet. The U.S. should see lower growth but should escape recession. If the global economy goes negative, however, the U.S. will follow.

Major central banks are going to use interest rates as one weapon against inflation. They have another weapon against inflation and are planning to trim their “quantitative tightening” to further restrict credit and economic activity. The U.S. Federal Reserve and its major counterparts in Europe, Japan, the United Kingdom, and elsewhere pumped in about $12 trillion in the financial system to fight the economic fallout of the coronavirus pandemic. With breakout inflation now the common foe, Morgan Stanley analysts recently estimated that the Federal Reserve, Bank of England, the ECB, and Bank of Japan could
see their portfolios shrink by $2.2 trillion over the next 12-months beginning in May, the expected peak of quantitative easing (QE). Since QE programs are relatively new in economic systems, no one is sure what will happen when you raise rates and reduce QE at the same time. Generally speaking, reducing QE acts like an interest rate increase, but an exact impact is hard to project. The Fed, from 2017 to 2019, trimmed its balance sheet by about $650 billion. That led to a shortage of banking systems reserves, a spike in short-term interest rates, and a quick reversal to put liquidity back in the system. Fed
policymakers view that as a lesson and will try and make the process run more smoothly in the future. Oxford Economics’ Adam Slater projects that balance sheet reductions could lead to the equivalent of adding as much as 1.3 percentage points to coming rate hikes. The risk of a mishap in the coming months is significant.

The U.S. and global economies have just seen a “Perfect Storm” of bad events, including a pandemic, supply shocks, inflation, a war, and the closing of one of the major manufacturing and trade hubs in the globe. We will be seeing aggressive central banks under pressure to stop runaway inflation. Certainly, downside risks have increased and the impact of all this could lead to recession. On the other hand, there are strengths. In the U.S. unemployment is low, the consumer is strong, and hopefully, there will be some break in this combination of events that made the “perfect storm.” Mathematically, negative
events cannot last forever. The next few months are likely to be confusing, as central bankers try to wrestle inflation out of the system, and things will get volatile. With good policy and some needed good luck, we are certainly capable of advancing out of all of this. In the long-term, even a modest recession might not be all negative; it would rid us of inflation.