Annual inflation indicators survey | Linchpin
This is Linchpin’s tenth annual update on the long-term outlook for inflation, in which we monitor a range of inflation indicators. Last year, following the vast stimulus provided by central banks and governments we forecast that supply side factors would lead to higher consumer inflation, especially in food and commodities. However, we did not see it as the start of a sustained rise quite yet. In 2021, the headline figures rose to 30-year highs and there are clearly significant supply side pressures, but we have not changed this view.
William Bourne 31st December 2021
Linchpin Inflation Indicators
Supply-side measures lifted inflation in 2021
Our nerve has been tested in 2021. 12 months ago we thought a sustained inflationary pick-up was some way away. However, the supply-side pressures have lifted consumer inflation to 30-year highs in the U.K. and U.S. and central banks feel constrained from tightening monetary policy because of the resurgence of COVID and slowing economies. Not surprisingly, the consensus has moved towards a more inflationary outlook. While we acknowledge the risk, and fully expect inflation in the future, we still see the current surge as more of a blip.
First, we review our 13 indicators. Compared to last year, the net score is little changed, with six pointing to inflation, four to neutral and three to deflation. The net score is +3 (+4 in 2021). Within this, there have been changes in both directions to individual indicators.
The global recession in 2020 was followed by an expected rebound in 2021 as the stimulus provided by the authorities kicked in. However, this started to fade mid-year as government fiscal support was withdrawn or reduced, and at the time of writing, growth is at or below the long-term trend rate in almost all major economies. Our demand indicators have therefore slipped back in aggregate.
On the supply side, our three indicators are now all pointing to inflation. Commodity prices, and especially energy, look likely to remain high for a ‘perfect storm’ of reasons. Increasing demand from China as its living standards rise, lack of investment in mining and fossil fuels for environmental reasons, and geo-political manoeuvring by Russia all play their part. Slowing global growth may be a mitigating factor, but not enough to move our dial. We also note that labour and regulatory costs continue to rise, respectively because of lower labour mobility from travel restrictions and stricter environmental and social legislation.
We have moved the over-capacity indicator to Inflation. This may seem counter-intuitive when growth rates are below trend. But we want to capture crucial component areas such as semi-conductors, where supply problems are constraining manufacturing (e.g. Chinese producer price inflation is above 10%). The result is forcing price rises in areas such as, for example, second-hand cars.
Monetary policy is moving towards disinflation
Policy action has moved in the direction of disinflation as central banks attempt to withdraw stimulus. Here we note a significant skew: the United States remains much looser than other central banks, perhaps because the Democratic political agenda, perhaps because Powell is proving a weaker governor than (e.g.) Volcker when faced with an inflationary impulse. Looking forward, however, we can expect more aggressive tapering. If this does not happen, a weaker US dollar is likely to add to U.S. inflationary pressures.
The other important actor here is China. Although the Chinese economy hardly grew in the third quarter amidst the travails in the property development sector, the PBOC did not appreciably loosen its stance. We think that is consistent with its new focus on stability rather than growth. That suggests that any future stimulus will be limited, and that inflation is likely to be subdued too.
Bond markets still point to low inflation
Finally, we turn to our four market indicators. Interest rates barely moved in most countries despite consumer inflation at 30-year highs. Conventional and index-linked government bond yields also remain at historically low levels, albeit a little higher than 12 months ago. The yield curve has flattened and convexity (the hump in the curve) increased, both of which are signs of slowing economic recovery. The U.K. is in one respect an outlier, in that the inflation level in five years’ time implied by the bond markets has risen from 3.2% to 3.9%, but other countries have not shown the same pick-up. We have therefore left this indicator at Neutral.
Our final indicator is the gold price. Gold has lost some of its allure as an inflation-hedge to crypto-currencies, and its price has been subdued in 2021. Investors have switched to the latter because they believe they are, like gold, less susceptible than paper currencies to debasement. It is too early to say whether this phenomenon will be sustained, but despite gold’s lacklustre performance, we have held the indicator at Inflation.
Current market inflation estimates
The inflation rate at the IMF advanced economies group is 2.8%, sharply higher than the 2021 figure of 1.2%. It is driven by the United States (4.3% on the IMF latest figure). Headline consumer inflation figures are much higher, and the U.S. reached 6.8%, the U.K. 5.1% in November. By contrast, China’s inflation rate was only 1.5%.
Perhaps the clearest indicator of the scale of the pick-up is the U.S. GDP deflator. On an annualised basis it rose to over 6% in 2021 2Q, the highest since 1981. The equivalent U.K. figure, albeit only to April 2021, was also over 6% and the highest since the early 1990s.
Sustained inflation is not yet here, but the risks are growing
Inflation has clearly hit centre stage in 2021. We cannot ignore levels not seen for 30 years in the U.S. or the U.K. The big question is whether the resurgence is already sufficiently engrained into consumer psychology that it will bubble along at more than 3% or more for many years, or whether it will fall back again. It matters greatly to investors, as the outcome will eventually have a significant impact on both equity and bond valuations.
As we said last year, the policies currently in place in the West make inflation inevitable in the long-term. Absent default or much higher levels of growth, government borrowing can only realistically be reduced by inflation. Some countries may prefer to run with high levels of debt, as Japan has for many years, rather than inflate it away, but that in turn constrains both monetary and fiscal policy. We do not expect many to take this route.
In the shorter term our forward-looking indicators have slipped back a bit. Market measures are pointing to inflation remaining low, although the supply side fundamentals and the long-term macro-economics continue to indicate in the other direction.
Our overall assessment remains on balance as last year, that inflation will fall back again in 2022. This is based on a relaxation of demand pressures as global economies slow down, some improvement in the supply-side as the world normalises after the last two COVID years, and a withdrawal of monetary stimulus from the U.S. We are not convinced that interest rates will rise significantly, as we think the global economy may flirt with recession.
However, we are not complacent either about the longer-term risk or about what could derail our calculations. Most likely is a policy error by central banks: i.e. the Federal Reserve feels the need to keep the monetary easing in place, and other banks follow. One second order risk here is of a much weaker dollar, and the effect that might have on sentiment towards dollar-priced commodities. Geo-politics in Russia or the Middle East could also intervene to disrupt energy supply, with a concomitant effect on energy prices.
In 2022 we will be watching bond markets and the yield curve most carefully, as we did in 2021. The first sign of inflation becoming more engrained is likely to be seen there.