How long will inflation remain elevated?

The third quarter of 2021 presented economic forecasters with a host of surprises: natural gas prices spiked by over 30% in one month, the 10-year US Treasury yield recorded one of its biggest one-week jumps of the year, and the US economy created less than 200,000 jobs in September. The debate rages on regarding whether today’s inflation will prove permanent or transitory. There’s a great deal riding on the answer since higher inflation would doubtless lead to higher interest rates and thus lower asset values.

Fed Chair Jerome Powell and many other believe that US inflation – which is currently running above 5% – will only remain elevated for a short period of time before falling back near the central bank’s 2% target. One reason for this is that while the inflation rate is high, it isn’t accelerating signficantly. In the 12 months through September, the Consumer Price Index rose by 5.4%, roughly the same rate as in the previous three months. Importantly, the month-over-month inreases recorded in July, August and September averaged 0.4% compared to 0.9% in June.

Wage increases also do not appear to be strong enough to sustain high inflation. In order for prices to continue rising rapidly, consumers need to have more money to spend moving forward. While many workers have seen their wages increase in 2021, this growth hasn’t kept up with inflation.

Also, consumption may slow despite the roughly $2 trillion in excess savings households amassed during 2020. Spending on durables spiked in 2020, indicating demand was likely pulled forward. Consumers may therefore buy fewer big-ticket items, such as appliances and cars, in the coming months. While spending on services may increase, such expenditure likely would not be enough to offset a substantial decline in durables purchases.

Consumer may also be reluctant to dip into their savings now that the economic recovery appears to be slowing. While economic data was mixed during the third quarter, the vast majority of surprises were on the downside. Moreover, consumer sentiment has fallen sharply, nearing a decade low in August.

Despite all of the above, dismissing the risk of persistently high inflation is unwise, partly because of the unique nature of the last 19 months. Before 2020, the world had never purposefully shut down a signficant percentage of the global economy and then tried to restart it. No one knows how long it will take for jammed supply chains to be eased and the labour force to be reconstituted. And the US has increased its money supply by roughly 30% in less than two years.

Finally, surging commodity prices may make many goods more expensive and impact the inflation outlook. The All Commodity Price Index has risen by over 30% from the pre-pandemic level. If Americans keep having to pay more at the pump and the grocery store, their inflation expectations will likely continue rising. Consumers already believe inflation will be 5.3% in one year and 4.2% in three years.

The probability that inflation will be transitory appears to be higher than the alternative, but probability isn’t certainty and inflation risk and interest rate risk remain greater than they’ve been in years. Getting this right is crucial for central bankers as the risk of a policy mistake would be very detrimental for the world economy at this juncture.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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