Transitory inflation? That depends on how quickly central bankers act

The key is the speed at which monetary and fiscal policy is tightened and how fast wage growth rises
Supply and demand imbalances will resolve but pressures from the labour market shortage and continued fiscal spending will linger

Kerry Craig

Published: 2:30pm, 1 Oct 2021

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The transitory nature of inflation has been tested recently amid expectations of an increase in prices, which is pushing up bond yields. Rising yields are having knock-on effects on equity markets as higher valuations become harder to justify.

Rising prices also create headwinds to economic growth as they can squeeze household purchasing power and depress consumer confidence. Inflation is likely to remain elevated in the near term for a variety of reasons but whether it proves transitory will depend on the extent that monetary and fiscal policy is left too loose for too long and how fast wage growth rises.

It is not surprising that inflation has moved higher in recent months. The lingering constraints in global supply chains are making it difficult for manufacturers to meet their orders and pushing up costs as companies scramble to get hold of important production materials.

Meanwhile, the pandemic has shone a light on the underinvestment in global transport logistics and the infrastructure needed to physically move goods around the world. These pressures are likely to linger and add to the prices paid by consumers.

Police detain activists from the Indian Youth Congress party during a protest against the government after prices were raised for petrol, diesel and liquefied petroleum gas, in New Delhi on September 2. Photo: AFP

Rising energy costs – not just of oil but for natural gas and thermal coal as well – are complicating the outlook. Even though energy makes up a relatively small 5-7 per cent of the inflation basket in developed markets, the wide swings in prices can be unnerving and are often felt more acutely by consumers when they fill their car up at the pump or pay their monthly energy bill.

However, supply and demand imbalances in energy markets are not new and an oil price of around US$80 per barrel is not going to ruin the economy.

The real test of whether higher rates of inflation can be sustained will be in the labour markets. Recent US data has shown there is plenty of demand for labour, and a sub-index from the National Federation of Independent Business showcasing the difficulty of filling jobs is at its highest level since the series began in the 1970s.

One argument is that the emergency unemployment benefits have dissuaded the jobless from returning to the labour market. Many US states began phasing out these additional benefits in July and the federal scheme ended in September.

However, this doesn’t mean workers will once again flood the market. Access to child care, schools reopening and general concerns around contracting Covid-19 may leave people hesitant about returning to low-paying work.

A “Now Hiring” sign is seen at a McDonald’s drive-through on July 7 in San Rafael, California. Photo: Getty Images/AFP

Eventually, workers will return, especially as the leisure and hospitality industries kick into high gear, but until then, higher wages and expectations of better pay will create more underlying inflation in the economy.

Higher wage growth is not a bad thing, especially if it means they are keeping pace with inflation, as this will offset concerns about the economic drag created by the squeeze on disposable income.

The message from central bankers has been that they are willing to tolerate higher rates of inflation after an extended period of too-low inflation. The rationale is that a little more heat in the economy can’t hurt.

However, the stickier rates of inflation mean that central banks’ forecasts are heading higher and the process of returning to more normal policy settings has begun, or will do soon in the case of the US Federal Reserve.

Central banks have been the heroes of the financial market story for some time, stepping in as a backstop, ensuring the financial plumbing still works, being willing to do “whatever it takes” and, more recently, blurring the lines of independence by creating a means for governments to ramp up spending.

But they are not without folly and the risk of keeping policy settings too loose creates an inflation risk when combined with governments that are still willing to spend. A too-slow approach now would mean having to catch up later should inflation become less transitory and more persistent, and be equally unsettling for markets.

Overall, while there are many reasons to believe inflation rates will stay above the 2 per cent target of central banks as we head into 2022, some of the price pressures will be transitory as supply and demand imbalances resolve, while others, such as the labour market shortage and continued fiscal spending, will remain as central banks start removing accommodative monetary policy settings.

Kerry Craig is a global market strategist at JP Morgan Asset Management

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