We’re all psychologists now

At the previous two Inflation Days we zoomed in on particular drivers of inflation including supply shocks, energy prices, labor markets and secular trends like globalization (or reshoring) and aging. However, this year we focused on the likely trajectory of inflation over the next 12 months.

External specialist speakers were invited to share their opinion on whether they expect inflation to return to targets set by central bank next year – or not. We would like to thank Stephen King (HSBC), Bruce Kasman (JP Morgan) and Bhanu Baweja (UBS) for their valuable insights.

Perhaps the key takeaway is that all speakers highlighted the importance of the psychology of inflation. Indeed, after almost two years of high inflation, households, firms and central banks are beginning to think differently about the threat of inflation.

Another important takeaway is how broadly engrained the consensus is around the higher-inflation-for-longer view. Note here the difficulty we had finding even one speaker who believed that sharp monetary tightening thus far was sufficient enough to put the inflation genie back in the bottle.

Even though we share the concerns of this consensus, we would like to stress that particularly food and energy commodity prices point to further headline disinflation going forward. Furthermore, supply chains continue to improve, which should bode well for core goods inflation. Lastly, we highlight the lingering recession risk as a potential driver of disinflation, a point acknowledged by all speakers.

Below, we summarize in more detail the discussed key drivers of inflation for the next 12 months by making the case for either above-target or at-target inflation.

The confluence of aggressive fiscal stimulus, monetary easing, supply chain dislocation, and untried movement restrictions has evoked a notable shift in analyst expectations from pre-covid confidence levels in the ability of central banks to deliver on inflation targets. So much so, it was difficult to find a voice to advocate for underlying inflation returning to target levels in the coming 18 months without causing a hard landing. Rather, there is a need to work through the consequences of these dislocations via consistently elevated organized wage demands (especially in Europe), ongoing labour market mismatches and overconfidence in now-outdated models that ignored potential dynamism in inflation expectations. As a result, G7 central bank pre-covid reaction functions may no longer be fit for purpose and political consequences expected from fiscal austerity against post-covid inflationary shocks further muddy the waters.

In the post pandemic era, the public reaction to high inflation prints seemingly ranged from ignorance and denial to surprise and acknowledgement. We are now reaching the next level of mental adjustment to price changes. Inflation, particularly when it starts from near-zero levels and is deeply forgotten, as in the post-GFC era, is a discovery process. Most people currently involved in economic life have not experienced a sustained period of rising prices and interest rates. This is a process of waking up and adapting expectations. What we have seen from successively higher inflation prints in the past few years is a progressive build-up of short-term memory that brings long-term references back to the 1970s, 1980s and/or to stagflation. We have seen inflation picking up in areas not hit by the supply shocks from the pandemic, but simply due to the spreading of the inflation narrative via various media channels. This process alone has created anxiety and fear, leading to a rapid rise in social and political concern. Even as headline inflation lowers, demands for higher wage growth could still persist – hence keeping core inflation elevated and limiting the drop in the headline rate.

Although potential political risk prompted pro-active responses from the likes of the Bank of Canada and the Reserve Bank of Australia, for many other central banks, high inflation re-introduces implicit fear over their independence. Notably, a perceived reserve to impede near-term growth prospects that risk political retaliation, especially in polarized environments like in Central and Eastern Europe. Admittedly, central banks tolerating modest inflation overshoots could further aid post-covid fiscal consolidation. Lastly, academic research investigating corporate responses to newfound pricing power indicates conflicting incentives risk, further stoking inflationary impulses . Notably, those that eschew price increases risk investor penalization via a falling share price, directly inducing negative wealth effects for management. As a result, while real policy interest rates may be higher than was the norm of recent decades, they may still prove too low to tackle the inflation challenges ahead.

Of course, there is also a case for lower inflation. Below we describe three trends that point to inflation decelerating. Firstly, inflation psychology seems to be changing. Rather than expecting an ever higher pace of price increases, surveys indicate public sentiment is turning disinflationary. Perceived inflation might play a role here. Some components of inflation are more visible than others. Gasoline pump prices are one example. Food prices are another. While these prices are seen as less relevant for the cycle, they do influence short term expectations for inflation. Indeed, expectations for inflation 12 months out have come down and consumer surveys for both the US and Eurozone now point to an expectation of 4%, or less. These expectations are now below wage growth levels. Fed research suggests inflation expectations influence wage demands. If the recent trend continues this could mitigate the stickier components of inflation via lower wage growth. This could be reinforced if food and energy price components drive headline inflation lower in coming quarters.

Another reason why (US) inflation could slow further is the delayed passing of lower rent increases. This is true for the US, where new rental contracts have started showing much smaller price increases from Q2 2022 onwards. However, these new contracts only have a partial to 3-4 quarters delayed impact on rents in the CPI basket. Research from statistical agencies such as the US BLS point towards a disinflationary impact from this source since October last year and recently confirmed these conclusions. Given the large weight of rents in CPI baskets, especially for the US, any material slowing in this category can easily lead to a 1-2% reduction in inflation.

Supply chains may have been permanently changed by the COVID experience, but many of the goods that were scarce during and immediately after the pandemic have become much easier to obtain. Cars are a good example of this trend. Production levels are rapidly recovering and inventories are being re-built, with the US leading Europe. As a result, the normal market dynamic, with dealers offering discounts, is gradually returning. In goods categories like these, which were an important source of inflation in 2021-2022, we might even see declining prices.

As previously stated, our third Annual Inflation Day saw all three external speakers highlight the importance of the inflation psychology of households and firms, which was seen as for a critical risk to price-wage spirals. They also noted the psychology of central banks, who, after almost two years of underestimating inflation, currently seem reluctant to set monetary policy based on expected future inflation (i.e. forward-looking), and instead navigate on actual underlying inflation trends (i.e. slightly backward-looking).

As regards to the psychology of analysts, the high-core-inflation-for-longer view seems to be a crowded consensus. Nonetheless, while weighing the cases for and against the issue presented above, we assign a somewhat bigger probability to a scenario in which lower headline inflation and weak economic growth, as well as some additional monetary tightening, prove successful in steering core inflation close to targets by the end of next year across many economies. Certainly, regional variation is likely to remain strong, with some regions (i.e Eastern Europe) and countries (i.e. the UK) probably lagging in this process, or struggling to generate sufficient underlying inflation pressures (i.e. China).

As for the inflation outlook on a secular (rather than a cyclical) horizon – for which drivers such as productivity, ageing, digitalization, robotization and AI, and global value chains were seen as more important – we remain humble (as we were among those underestimating the inflation threat two years ago). Additionally, it is worth mentioning that the uncertainty about where inflation in the US will settle in five years’ time, according to the options market, is the highest in more than 10 years. That said, eyeballing the forward spread between yields on conventional long-term bonds and inflation linked bonds in the Eurozone (of almost 2.80%), and comparing this to the ECB’s inflation target of 2%, we cannot help but think that financial markets may have run a bit ahead of themselves in embracing a secular higher inflation regime. Indeed, among investors there could also be extrapolation inflation at work.