The transitory inflation narrative is dead.
Central banks have been forced to admit they got it wrong.
Measures of inflation remain elevated and inflation expectations have loosed their
anchors.
US consumer one year ahead inflation expectations rose to a
record high 8% in June, from a revised 7.5% in May. CPI inflation has risen to a 40-year
peak. The question now facing market participants is whether inflation has peaked or is
becoming entrenched. This will have long-term consequences for asset prices.
The question of entrenchment hinges on pay – whether wage-price
spirals develop. The risk of this is currently high. Consumers are seeing big increases in
food and energy costs, which they cannot ignore and is impacting behaviour. We saw UK
retail sales volumes decline in the month immediately after the household energy price cap
doubled. And with real wages declining amid a very tight labour market, employees will
seek to make up for lost purchasing power.
Such is the current trajectory of inflation, one major
organisation that oversees central banks around the world thinks we are on the verge of a
“paradigm shift” in the global inflation regime.
“We may be reaching a tipping point, beyond which an inflationary
psychology spreads and becomes entrenched,” says the Bank for International Settlements
(BIS).
The years after the Great Financial Crisis, deflation seemed to
be entrenched. Japanification was the watchword in Europe as monetary policy tried in vain
to raise inflation. Things are changing it will be difficult to correct. The BIS report
notes that “transitions from low- to high-inflation regimes tend to be self-reinforcing”.
Or as German economist Karl Otto Pohl put it, inflation is like
toothpaste. Once it’s out, you can hardly get it back in again. So, the best thing is not
to squeeze too hard on the tube. There is no doubt central banks were squeezing too hard
on the tube during the pandemic. I argued in August 2020 that the Federal Reserve’s shift
to average inflation targeting would see inflation expectations become unanchored just as
they did in the 1970s.
The more you let inflation off the leash, the harder it becomes
to get it back under control. BIS notes high inflation regimes lack the kind of
self-stabilising characteristics of a low inflation regime. High inflation regimes also
undermine central bank credibility, further unmooring the inflation process.
“Transitioning back from a high-inflation regime can be very
costly once it becomes entrenched,” the report concludes. “All this puts a premium on a
timely and firm response. Central banks fully understand that the long-term benefits far
outweigh any short-term costs. And that credibility is too precious an asset to be put at
risk.”
What does this mean for central banks and markets? BIS’s warning
is clear enough – time to hike rates and control inflation by any means. The Fed is
listening, but the ECB is dragging its feet. Even as Spanish inflation jumps above 10%,
the ECB is looking at a new bond buying tool to purchase peripheral debt to prevent
spreads from widening. It’s not even raised rates yet and has only indicated it will raise
rates by 75bps by September. But I don’t believe this level of inaction can last much
longer, which could create volatility in financial markets. Notably we can expect European
bond yields to widen, although the anti-fragmentation tool – as yet unannounced – will be
designed to prevent this.
It is ironic that the ECB, which struggled more than most with
years of below-target inflation, is now perhaps the most at risk of finding itself in an
inflation trap.
The stakes are high. “The overriding near-term challenge is to
prevent the global economy from shifting from a low- to a high-inflation regime. In doing
so, policymakers will need to limit the costs to the economy as far as possible and to
safeguard financial stability. Some pain, however, will be inevitable. As historical
experience has shown time and again, the long-term costs of allowing inflation to become
entrenched far outweigh the short-term ones of bringing it under control.”