Three things come into play when forecasting future inflation. First of all, the difference between supply and demand. At macro-economic level, an estimate is often made of the output gap, or the tightness of the labour market. In addition, the current inflation level also plays a role. Inflation is reasonably inert, well-anchored and responds slowly to changes. It takes time for a different inflation level to sink in with consumers and producers.
That is precisely the risk of inflation remaining high for longer. Apart from these relatively easy to determine components, inflation expectations play perhaps the biggest role in estimating future inflation. If inflation expectations remain constant, central bankers will tend to regard higher inflation as temporary.
Raising prices & wages
Higher inflation expectations cause companies to raise prices and workers to demand higher wages. Post-Covid in a tight labour market, this goes relatively smoothly. Inflation expectations also play a role in the central bank’s credibility with regard to policy objectives. In both Europe and the United States, the inflation target is currently 2%. For a long time the ECB was on the path of below, but close to, 2%. That has now been raised to 2 per cent. The Fed has moved - in retrospect, at an unfortunate moment - to the inflation target of 2 per cent.
If inflation had been below 2% for an extended period, it was allowed to exceed 2% for as long as it took to return to the long-term trend path of 2%. This has now been achieved, as inflation in the United States is now above 2% in almost every period. In fact, the gap is so wide that the high inflation rate is putting confidence in central banks at risk.
No general figure
There is no general figure for inflation expectations. There are different indicators that produce different results for different parts of the economy and over different periods of time. Inflation expectations are sometimes determined on the basis of surveys and studies of companies and consumers.
Nowadays, it is popular to take inflation expectations based on the difference in return between inflation-linked loans and normal bonds. The latter inflation expectations are almost always much lower than those based on surveys. This is primarily because a quarter of inflation-linked loans are still on the Fed’s balance sheet. This keeps inflation expectations artificially low and creates the Fed’s own confirmation that monetary policy is going in the right direction.
In practice, consumers and producers seem to ignore these long-term inflation expectations derived from financial markets. Ever heard of it being referred to in a collective agreement? When adjusting prices in contracts, employees mainly look at the short-term pain in the wallet, for example how much energy and food prices have risen in the past year, and project this increase into the future. Employees therefore base their wage demands on the here and now, not on what the financial markets expect in terms of inflation. Now, the gap between these short-term inflation expectations and long-term inflation expectations has widened sharply.
Dismissing expectations
The central bank dismisses the higher inflation expectations in the short term as a consequence of supply problems or the result of the end of the Covid crisis, but it is striking how synchronised core inflation and wage developments are starting to be with these short-term inflation expectations. Thanks to the tight labour market, it is relatively easy to negotiate higher wages, especially in the United States. The gig economy is growing and there is hardly anyone who cannot negotiate a higher salary when changing jobs.
The power of the trade unions may have paled in comparison to the level of the seventies, but through social media it is easy to organise actions in a short period of time that employees in the seventies could only dream of. The power of social media - both in the corona crisis and in the Russian invasion of Ukraine - is once again underestimated.
Markets seem convinced
Financial markets seem convinced that central banks will succeed in bringing inflation back to the 2 per cent level in the short term. At least, that is what the inflation forecasts based on the difference between TIPS and normal bonds show. That might be possible if the central banks did everything in their power to achieve this objective. But they are not going to do that.
The market is counting on the Fed’s policy rate peaking at 3.3 per cent and cutting it again early next year. The current generation has no experience of these high inflation levels and believes that we are returning to the days of Goldilocks. There is too much confidence in central bankers, the same central bankers who have proved to be regularly wrong in recent years.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. His contributions to Investment Officer Luxembourg appear on Thursdays. This column originally appeared on InvestmentOfficer.nl.