Inflation Warning Signs Start to Develop
Chris Kuehl, Ph.D.
This recession has had almost too many too count unusual aspects. It was a sudden and imposed recession; and thus, it came without warning signs that would have allowed governments and business to prepare.
The shutdowns created massive unemployment issues from the start—the U.S. rate of joblessness went from 3.5% to more than 15% in a month. Several factors generally drive inflation, but none of these seemed to play a role. Even before the surge in unemployment, there was little in the way of wage inflation (the Phillips Curve has not been working for some years).
The costs of commodities also stayed low as demand faltered. The price per barrel of oil had tumbled to less than $20 at one point and has been languishing in the $40s throughout the year. Even the surge in money supply has not been enough to trigger an inflation response but that may not last a lot longer. The threat of inflation is rising along with the expectation of an economic recovery sometime in the coming year.
A number of indicators are used to gauge the potential for a surge in inflation, and these are starting to send warning signs. The 10-year-break-even rate is derived from prices of U.S. inflation protected government securities. That rate hit 1.83% yesterday; that is the highest point reached since May of last year. A swap rate that measures expectations for inflation five years from now has hit 2.25%; that is above the 2.0% target the Fed had set for inflation. That swap rate was at 1.2% at the height of the pandemic crisis and now signals that there is growing confidence in economic recovery in the coming year.
The thinking is pretty simple. The money that has been poured into the economy has been considerable. Under normal circumstances, that would have been enough to boost the risks of inflation. The consumer would have more money to spend the economy out of recession and producers would have the flexibility to hike prices a little as demand spiked. This time the ability to spend that money was curtailed by the lockdowns. It has been estimated that some 65% of disposable income was being spent on services prior to the pandemic and the bulk of that outlay was negatively affected by the lockdown.
The fact is that much of that stimulus money is still out there just waiting for an opportunity to hit the economy. The expectation now is that it will do so all at once. Central banks all agreed their focus would be on growth and recovering jobs, and they were prepared to tolerate much higher levels of inflation than would have been the case in the past. However, if there is a real surge taking place next year, that tolerance may erode quickly. The sense is that people and business will resume their old patterns as quickly as they can.
There was some expectation that there would be slow resumption of old patterns, but the evidence has been pointing to far more rapid return. The population has not really adjusted to a new reality as much as it has tolerated the interruption. The majority of polls suggest that people are eager to return to restaurants and events, and they are eager to travel again. The business community seeks to resume conferences and shows, and salespeople want to get back on the road. Even the initial enthusiasm for remote working has faded to some degree.