Inflation’s paradigm shift, explained

The global economy is under attack from an insidious force: inflation. How entrenched in the psyches of consumers, corporates and investors future inflation expectations become will foretell the durability of the foe, and its corrosive impact on the global economy, for (potentially) years to come.

Economic forecasts remain sanguine about the future level of inflation: testament to the confidence maintained in central bankers’ abilities to squash it. Yet convictions can shift rapidly, shredding widely held conventions. Rather than a return to past trend of subdued year-over-year price increases, might the global economy be entering a new paradigm: a period defined by higher and more volatile baseline inflation?

A long period of subdued price increases—supported structurally by increased global economic integration, technological advancements and favourable demographics—enjoyed by consumers, businesses and investors around the world has been upended. Supercharged by COVID-19 stimulus payments, prices began to leap in 2021 as countries emerged from lockdowns. Consumer demand jumped because of pent-up demand; economic activity propelled forward. Optimists initially described the resulting inflationary spike as transitory—the reality of the situation is anything but.

By June 2022, inflation in the United States hit 8.6%, a 40-year high. Meanwhile, inflation across the European Union was 10.9% in September 2022. In Türkiye, officially tabulated inflation hit a staggering 54.8% in the first quarter of 2022, while unofficial accounts point to a threefold multiple of that number. The list goes on.

In response, major central banks—including the US Federal Reserve and the European Central Bank, among most others—raised interest rates to slow economic expansion and rein in inflation. While there are some signs of price moderation triggered by slowing aggregate demand—for example, the price of brent crude has fallen 25% since March—price indexes across regions and industries remain unacceptably high. Nonetheless, some of the most critical asset markets in the world have by and large bought into the prowess and efficacy of central bank inflation fighting capabilities, projecting low levels of inflation in the future. Thanks to exceptionally well calibrated monetary policy, the stipulated future will consist of a modest economic downturn rather than a deep recession and the return to more accommodative monetary policy in 2023.

Such a sanguine forecast may prove premature.

Increasingly, experts suggest that higher prices may prove more intransigent and volatile than expected. For this reason, the World Economic Forum’s most recent Chief Economists Outlook declared this moment a “time of significant economic danger.” The outlook noted that sustained high inflation is a major burden for consumers—especially low-income communities—since it acts as a regressive tax, hitting lower income households disproportionately hard.

Low-income communities are more vulnerable to economic downturns due to low savings rates and job insecurity. For example, if the goldilocks scenario of approximately 2% forward inflation and a shallow recession do not materialize in the US, the Federal Reserve will be forced to continue raising rates, further tempering aggregate demand, crimping employment and exacerbating already notable affordability crises, like those seen in housing markets. The same dynamics exist globally as outlined in a recent analysis from Swiss Re that remarks: “with persistent and broad-based inflation, monetary tightening must continue, even at the cost of a deeper recession and/or market correction.”

At a recent closed-door discussion held during the International Monetary Fund’s (IMF) annual meetings in Washington D.C., a central bank governor from a significant emerging market economy reminded executives gathered how instructive the emerging market experience in fighting inflation could be. “Based on learnings form emerging economies, the path toward bringing down inflation is never linear. But forward curves in developed markets are surprisingly linear at this moment—which would appear incompatible with historical experiences in other parts of the world,” the governor stated.

A growing chorus of voices from the private and official sectors are also pointing to a more cautionary future. “The past two decades of ‘2%’ inflation, growth, and wages have ended,” Bank of America noted in a recent Global Research analysis. “We’re moving back to a ‘5%’ world.” The IMF also reported that global inflation is expected to fall to 6.5% in 2023 and then to 4.1% by 2024. “We expect global inflation to peak in late 2022 but to remain elevated for longer than previously expected,” the IMF stated in an October report.

Additional factors further complicate the role of central bankers in controlling inflation, as these factors transcend the mandate of any one monetary authority. These include supply chain challenges stemming from lockdowns in China, climate change related food shortages, interlinkages between rising energy and food prices, demographic changes such as aging populations, reshoring and friend shoring, “greenflation”, China retrenchment or isolation. Unabated, these drivers may provide unwelcome ballast to global inflationary pressures.

Indeed, it may take more than a few quarters of tough love from central banks to obliterate inflation.

Certainly, the collateral damage in terms of economic loss, unemployment and asset value depreciation (already demonstrable) are difficult to predict. Mindful observers of capital markets speak of emerging fault lines in financial systems brought by rising interest rates. Among the more common unintended consequences originating from rising rates is financial instability, as the global financial system endures increasing stress from liquidity leaving the system, and long duration assets portfolios constructed during a low-rate environment get hammered. Finally are the unintended political shifts and socioeconomic tensions wrought during times of greater austerity.

Perhaps the optimists will prove clairvoyant, and the world will return to the modest real growth environment of recent memory with price volatility well under control. Yet if history is any guide, consumers, businesses and investors might be better served preparing for leaner and less predictable times ahead.