The highly anticipated jump in inflation has arrived. While the sustainability of the rise remains open to debate, recent readings have surged and some measures of inflation expectations are showing sizable increases.
For many, the speed at which inflation has accelerated has been the most eye-catching development. In the US, the blow-out consumer price index numbers for April and May boasted the largest gains in core prices in decades. Some of the upward moves, such as the rise in airline fares and hotel prices, point to rebounding demand and a return to pre-pandemic price patterns. But other increases reveal deepening bottlenecks. Most notably, used car prices are up sharply as microchip shortages have constrained new vehicle production and pushed up demand for second hand ones.
Such developments are not restricted to the US. The global economy is bouncing back with surprising vigour and commodity markets have tightened appreciably. Notably, oil prices have climbed back to pre-pandemic levels. Many metals and agricultural commodities have posted even larger price gains, as rising demand has been reinforced by supply constraints. Going forward, commodities prices are likely to remain firm but will moderate as gross domestic product growth slows towards its trend and supplies pick up.
More broadly, the pandemic has seen consumers substitute services with goods. And the production of these goods is stretching suppliers. This is true in sectors ranging from toys to tech. Surging goods demand, in turn, has driven supply-chain bottlenecks, as producers have desperately sought to keep up. Surveys continue to show increased backlogs and slower delivery times.
These developments have translated into sharp increases in producer prices in countries around the world. This move is particularly notable when contrasted with the historically soft readings during the depths of the pandemic. Even so, the pass-through of rising producer prices into CPIs is generally still in its early stages in most countries, with the notable exception of the US, where the strength of demand is providing scope for firms to pass through cost increases for commodity-intensive products.
But stepping back, we see the evolution of global inflation through the pandemic as broadly driven by shifts in relative prices more than across-the-board increases in prices. These shifts started last year with a collapse in global core services inflation, which was averaging 2.5% before being decimated by lockdowns. The shift in relative prices also affected global core goods, where inflation has moved up during the pandemic.
An important question is how inflation will revert as the recovery gains steam. The rebound in services demand is likely to push services inflation back toward its pre-pandemic pace. Evidence of this has already been seen in recent US CPI numbers. In addition, the ‘income effects’ associated with the strong global recovery mean that the demand for goods should remain solid. The result is likely to be more inflation in the near term.
As the year progresses, however, aggregate supply is likely to catch up with demand and bottlenecks in global commodities and other goods markets will be resolved. Complementing this dynamic, the rebound in services prices is likely to be self-limiting. The demand for services will not rise indefinitely. And, if anything, it may be a notch softer than before the pandemic as economic action shifts toward virtual activities. The price of some products may remain high for a while. But inflation requires persistent, ongoing price increases.
Over time, deeper structural factors are likely to assert themselves, restraining aggregate demand and keeping inflation in check, as before the pandemic. These include aging global demographics, elevated debt levels and the onward march of technology and innovation. In addition, recent soundings from Federal Reserve officials suggest that the unexpectedly strong inflation readings may trigger a tapering of asset purchases earlier than previously expected. And a half dozen emerging market central banks have recently started hiking rates. Accordingly, we see inflation pressures gradually easing later this year and early next year.
The global inflation story is one that we’ll no doubt need to revisit often in coming months and we’re mindful of the factors that could keep inflation high. Nevertheless, the current frenzy of inflation pressures is poised to ease. Over time, the economic environment is likely to resemble what we saw before Covid-19 erupted, rather than one where the pandemic has launched a new paradigm of persistently elevated demand and higher inflation.
Nathan Sheets is Chief Economist and Head of Global Macroeconomic Research at PGIM Fixed Income.