High inflation: how concerned are we?

Like all prices, the overall price level is determined by demand and supply. A change in the price level can then be broken down into shifts in demand or supply. Last year’s outbreak of the Corona pandemic has led to a sudden slump in global economic activity. Governments all over the world put policy measures in place to cushion the economic fallout. Central banks restarted or enhanced their asset buying programmes. All of this led to a quick recovery of aggregate demand in economies all over the world. Aggregate supply – the production side of the economy – could not keep up with this pace, though. Delivery chains have been disrupted because of pandemic-induced frictions in global logistics and temporary production stops in Asian factories. In addition, consumption patterns changed during the pandemic, with demand for goods increasing and demand for services declining. Many firms were unprepared for this change in consumer behaviour.

On balance, aggregate demand quickly recovered. Aggregate supply, however, continues to be constrained, as the issues on the production side have not yet been resolved. Rising demand meeting constrained supply almost always ends up in higher prices. This is what we are currently witnessing. On top of that, rising energy prices add to overall inflation and eat into consumers’ budgets. This increases the risk of second-round effects: firms raising retail prices and workers asking for higher wages. 

We see the risk that inflation could stay longer on elevated levels than previously expected. On the other hand, delivery chain disruptions should start to resolve. Global shipping freight rates now seem to peak. Current month-on-month inflation rates are already back to more normal levels. The diminishing base effect (i.e. the effect of high year-on-year inflation rates due to a very low price level in the previous year) will bring year-on-year inflation rates down in the next months. We expect energy prices to peak early next year. Most importantly, aggregate demand is not far away from pre-pandemic levels and will therefore not grow as fast as in the last months, whereas aggregate supply will be recovering. 

This does not mean that inflation will return to the low levels of last year. During a cyclical upswing it is normal that inflation is rising. We do not have to be overly worried about this, as long as higher inflation goes hand in hand with the increase in overall economic activity. This is also important with regard to monetary policy. Strong economic growth should be accompanied by central banks carefully raising interest rates, to prevent the economy from overheating and bring it back on a balanced growth path. 

We do expect an ongoing strong recovery of the world economy with growth rates well above their long-term averages. This is a good environment for equities and explains our overweight positioning in this asset class. It is possible that inflation will remain higher than previously expected. We have prepared ourselves for this scenario, by looking into different equity sectors and asset classes and how they react to rising inflation. For the moment, however, we do not expect this scenario to play out. In our main scenario we expect delivery chains to be restored. This will relax supply side constraints and ease inflation pressure. Inflation might stay elevated for some time but the worst in terms of price acceleration is very likely behind us. We also expect central banks to look through this and to maintain their supportive monetary policies (ECB) or taper their asset purchases very carefully (Fed) in order to avoid harsh market reactions. 

Thomas Domeratzki

Senior Strategist
Global Investment Centre | Global Asset Allocation Services