Embedded inflation

2 years ago

The term transitory was much used to describe inflation by the US Federal Reserve (Fed) last year, before being abandoned. This year the greater concern could be embedded inflation. While the former was the central bank equivalent of ‘nothing to see here’, the latter is a more serious matter. We take a look at how inflation becomes embedded, how recent events could contribute to this trend and how this raises the temperature of financial markets.

Demand snapped back

The Covid-19 pandemic brought an unprecedented collapse in demand for goods and services, as economies were left paralysed. As normal life resumed, demand snapped back quickly, in particular for consumer goods such as electronics and cars. Prices can only remain stable when demand and supply are roughly in balance. Post pandemic this was very far from the case. Fractured global supply chains meant that cash rich consumers were chasing a restricted number of goods. The result was price inflation.

Temporary hitch

The hope and expectation of central banks the world over was that this was a temporary or transitory state of affairs. And one that would pass as supply chains were fixed. There were forecasts that demand would also ease. But fiscal stimulus and overflowing savings accounts meant that demand remained strong. And it’s not just for consumer goods. Commodity prices have been hit by one off factors, such as extreme weather in Brazil. And now geopolitical events have thrown the international energy market into turmoil.

Or persistent problem

The resulting price spikes have been dramatic. But inflation only becomes truly embedded once the expectation that prices will continue to rise becomes set in stone. This is usually cemented by wage demands. Workers might demand higher pay to match the rising cost of living, it’s known as wage inflation. The result can be that, with more money washing around the system, demand is fuelled further and prices pushed ever higher. At worst, wages rises can spiral out of control.

Central bank dilemma

It’s a vicious circle and one the central banks are keen to avoid. Hence the ‘hawkish pivot’ on interest rates late last year, predicting a steady pace of increases in 2022. The Russian invasion of Ukraine has certainly reset the dial. Central banks now face two opposing risks. The first is that inflation forecasts become ‘unanchored’, rising sharply and driving wage inflation. The forecast for US inflation one year from now has jumped from 3.5% to 5.24% since the invasion. The second is going in too hard on rate hikes, which risks choking off the recovery.