Inflation is the risk to watch

Risky assets have had a buoyant start in 2021. A strong pickup in global growth, the prospect that this will continue and significant support from central banks and governments has been a wonderful backdrop for investors. What could possibly go wrong?


03/06/2021 – Nick Kounis

The key risk to watch – certainly in the US – is inflation. A sharp and sustained rise in inflation would force the Federal Reserve (US central bank) to step on the brakes much faster and harder than currently expected. So how likely is the return of inflation?

It is first important to distinguish between transitory trends in inflation and a more sustained upturn. This year, inflation has accelerated around the world on the back of the unwinding of last year’s fall in oil prices. Annual inflation rates will likely rise further. In particular, the reopening of economies could lead to some normalisation of price levels, with annual rates of inflation jumping even more, given price declines when economies first entered lockdowns last year. These factors will likely dissipate in 2022.

For a sustained and significant rise in inflation, the economy would need to overheat and remain red hot for years rather than months. Economic growth would need to be strong enough to create capacity constraints, not least in the labour market. Prolonged labour market tightness would lead to a sharp and sustained acceleration in wage growth. Companies faced with excessive demand for their products and services would need to have the pricing power to pass on higher labour costs to their customers. Underpinning this process would be a jump in inflation expectations, which would encourage higher wage and price setting.

Arguments in favour of this scenario

The case that this scenario would unfold in the coming years is as follows. US demand will rebound much more quickly from this recession than in the past, as the economy had been closed by the authorities rather than due to a more traditional shock that the private sector would need time to digest. Furthermore, excess household savings have been built up -- equivalent to more than 8% of gross domestic product, which could fuel a long and powerful consumer boom. Finally, the paradigm shift in macroeconomic policy – due to the recent enhanced monetary-fiscal cooperation and the Federal Reserve’s new inflation “make-up strategy”, where it allows inflation to run a bit over target levels as the economy recovers, could push up inflation expectations.

Case against this scenario is more compelling

We do not believe that this will occur and believe that the case against it is more compelling. Although we are likely to see blockbuster growth in the second half of the year, economic growth will likely slow to strong but less impressive growth rates in 2022. Moreover, not all the savings will be spent, as it is skewed towards more wealthy households that have a lower propensity to consume. Fiscal policy will also likely be much less accommodative next year. Crucially, the labour market is currently far from being tight. The true jobless rate is currently around 9%, compared to below 4% before the covid-19 shock. Even in 2018-2019, when unemployment levels were low, there was not much inflationary pressure. Periods of high inflation in the past – such as the 1960s – were preceded by many years of tight labour markets before inflation took off. Overall, we do not expect sustained high inflation over the coming years. Nonetheless, it is certainly the risk to watch.

Nick Kounis – Head Financial Markets Research

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