As we passed the one-year mark from the onset of COVID-19, business activity is recovering from lockdowns amidst a progressive rollout of vaccines.

In combination with fiscal stimulus, the gradual reopening of economies threatens to push global output above potential levels, triggering inflation.

A look back at the late 1960s and early 1970s in the US shows the potential danger: after remaining low and stable from the early 1950s to the mid-1960s, inflation rates started to rise as the US Federal Reserve (Fed) failed to tighten policy appropriately, losing credibility in the process. Fiscal policy then added further fuel ahead of the first oil shock. Only after Fed Chairman Volker aggressively raised rates (and created a recession) did price pressures moderate.

In order to assess how seriously we should take this possible overheating, let’s remember that inflation tends to be driven by two factors.

The first factor relates to the supply and demand balance, or lack thereof: inflation jumps when there is excess demand relative to supply. This can happen either when demand suffers persistent increase – to which supply cannot easily adjust, if already operating at full capacity – or when there is a shock that makes supply drop. The former creates persistent inflation, the latter does not.

The second factor has to do with expectations. If consumers expect prices to go up in the future, they will either demand higher wages to preserve their purchasing power, or they will buy now to avoid having to pay more later on. Inflation then becomes a self-fulfilling prophecy.

The increases in inflation since last summer seem to be mainly driven by supply rather than demand:

  • Global suppliers struggled to predict demand for their products as countries were caught in a stop-and-go pattern of reopening. This created shortages in areas such as semiconductors.
  • Containers and container ships (which had been taken off circulation) were not made available quickly enough as the world started to reopen. This generated dislocations in global supply chains.
  • When COVID hit, many firms decided to run down their inventories to preserve liquidity buffers. As economies reopened, stockpiles were too low.

As well as base effects, this is the main reason why our base case is for a temporary rise in inflation in coming months, followed by an easing in underlying price pressures through the course of the year.

For us to change this view, we would need to see a move towards a demand-driven supply/demand imbalance. The jobs market should fully recover alongside a rise in wages in line with overall inflation. It is true that government stimulus checks are reducing labour supply in the US as it makes people want to stay home, but these are due to stop in September.

In the meantime, the Fed does not seem that concerned about inflation (yet). Part of the reason is their belief that they have policy tools – from forward guidance to rate hikes – to control excessive inflation.

On June 16th, not long before the writing of this, the Federal Open Market Committee (FOMC) sent a clear signal that that they are in control and will respond accordingly to ensure long-term growth, full employment and crucially, keep inflation in check despite all the uncertainties. The Fed predicted interest rate rises in 2023 instead of 2024.

To read the full AndPapers Q3 2021 click here.

To get more US Expat content direct to your inbox monthly, sign up to our newsletter here.

 

 

 

 

Disclaimer: The value of investments and any income from them can go down as well as up and investors may not receive back their original investment amount. This communication is for information purposes only. It is not intended as a personal recommendation of particular financial instruments or strategies and it does not provide individually tailored investment advice. This document provides the views of the London & Capital Investment Team examining the fundamental background, economic outlook and possible effect on asset markets. This document is not an invitation to subscribe and is by way of information only. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be solely relied on in making an investment or other decision. If you are considering investing, you should consult your London & Capital adviser. The views expressed herein are those at the time of publication and are subject to change. Correct at time of going to press.
London and Capital Asset Management Limited is authorised and regulated by the financial conduct authority, 12 Endeavour square, London, E20 1JN. Firm reference number 143286. Registered in England and wales, company number 02112588. © London and Capital Asset Management Limited. All rights reserved. London and Capital Wealth Advisers Limited is authorised and regulated by the UK Financial Conduct Authority (firm reference number 120776) and by the U.S. Securities and Exchange Commission of 100 F street, NE Washington, DC 20549, with sec firm reference number 801-63787. Registered in England and Wales, company number 02080604. © London and Capital Wealth Advisers Limited. All rights reserved.