(HSBC Bank plc, 23.Aug.2021) — Amid vast uncertainty, inflation has spiked raising fears that price stability is over. The risks of “error” – in both directions – have risen hugely.
Late expectations
Those most relaxed about inflation typically point to an absence of any serious increase in inflationary expectations. This approach is problematic. Expectations are often slow to respond to changing conditions and, in any case, are too volatile to be relied upon. Worse, forecasters tend to “hug” inflation targets, thereby limiting the usefulness of projections at times of structural upheaval.
A different angle
The biggest danger is a sustained increase in inflation for any given rate of economic growth. Currently, there’s no shortage of threats. “Building back better” offers a throwback to Lyndon B Johnson’s ultimately inflationary “Great Society”; central banks have been given an increasing number of – at least in principle – conflicting objectives; quantitative easing has potentially unleashed a “backdoor” version of fiscal dominance; and, exacerbated by the COVID-19 pandemic, supply side conditions are no longer as favourable as they once were.
Not everything is inflationary
Still, a precise repeat of the inflationary 60s and 70s is unlikely. “Cost push” and “competing claims” versions of inflation are now less threatening: unionisation has fallen; robotics and other forms of automation have reduced the threat of damaging strikes; and labour markets are increasingly atomised thanks to the rise of monopsonist employers and hiring “apps”. Still, unless these factors intensify, the risk is that once-tranquil price pressures build more sustainably.
Five scenarios
With heightened uncertainty, rather than set out one explicit forecast, we set out five scenarios, an approach policymakers themselves should be keen to embrace. The most likely outcome may still be “business as usual” – previous warnings of higher inflation have come to nothing – but other scenarios now look much more plausible than pre-pandemic. We most fear a “delayed policy response” scenario, in which eventual tightening has to be more aggressive – and, hence, more economically damaging – than would otherwise have been the case, alongside a “scattergun” scenario, in which inflationary outcomes increasingly vary from country to country, implying a substantial increase in currency volatility. Overall, the return of inflation is a bigger danger now than at any previous point since central banks collectively began to enjoy their independence in the 1990s.
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