Chief Economist's View 

Download the PDF version including our economic update by region here: Should we be fearing the inflation bogeyman?

Since their low points in April last year, at the height of the first wave of the pandemic, global bond yields and inflation expectations have grinded higher over the remainder of 2020. We’ve seen another leg higher over the first weeks of 2021, with US & Australian 10-year bond yields up around a ¼ of a percent and back to their pre-COVID levels.

Yesterday we received the US January inflation report, which was soft and weaker than expectations, with US core inflation dropping slightly to an annual rate of 1.4%. What’s happening to inflation?

Over the month, US price growth stalled, with the weakness still concentrated in virus-sensitive goods and services such as airfares, hotels, and recreation. Core inflation excludes energy prices, so it missed the upward pressure from the rise in oil prices, so that the headline inflation number rose by 0.3% in line with expectations.

Nonetheless, both headline and core inflation are rising at an annual rate of just 1.4%, significantly below the Fed’s target, which would be around 2.2% on the CPI measure of inflation. And we’ve seen the US experience mirrored in Australia, where our latest CPI read shows annual inflation at just 1.3% for core inflation.

In fact, core inflation hasn’t broached 1.7% in the US or 1.4% in Australia since the onset of COVID. But markets seem to be anticipating a rapid pick-up in inflation, with US and Australian inflation expectations at multi-year highs.

What is driving the market’s view? We can identify four basic drivers.

First, we will see a bounce in inflation as COVID policies that have been suppressing inflation are unwound, such as free childcare in Australia and health care policy changes in the US. Second, the impact of rising oil prices will continue to lift inflation over the coming year.

Third, a sharp pick-up in global growth in the second half of the year as vaccines are rolled out and large fiscal packages in places like the US and Europe are unleashed. Finally, major central banks like the Fed and the RBA are going to allow inflation to run a little hotter than their targets until they are sure that price growth won’t slip backwards.

But of course, inflation has occasionally threatened over the last decade, but never really materialised. Is this time different and the market’s right; should we now be fearing inflation?

Certainly, the market expects inflation to pick up and so do we. But current market pricing is far from a fear-inducing inflation blowout.

Equity markets also don’t seem to be too fazed about inflation. Bond yields have been rising in line with inflation expectations, as you would expect, but at an orderly pace and equities have been absorbing the rise in inflation expectations and bond yields throughout 2020 and into 2021 without so much as a hiccup.

But are we and the market becoming complacent about inflation risk? The recovery in the US, Australian global economies and the labour markets have been quicker than expected, the vaccine is being rolled out sooner than anticipated, the US is about to unleash a $1.9 trillion fiscal package and central banks are committed to pumping liquidity into the economy.

Surely there’s a risk central banks get caught out and we do get an inflation blowout? We agree that we will see strong economic growth over 2021, especially over the June and September quarters and especially in the US. We expect the US economy to grow by 5.2% this year, about 2½ times faster than we would expect in a post-COVID world and that the unemployment rate will fall from its current level of 6.3% to 5% by year end. But strong growth on its own does not induce an inflation blowout.

Currently, there are 10 million less workers employed in the US than back at the start of 2020, before the COVID outbreak, and even with the strong growth that we are expecting and the unemployment rate falling to 5%, there will still be around 3 million less workers with jobs in the US than before the outbreak and about 8 million US workers unemployed by the end of the year.

With that number of workers unemployed, wage growth will remain tepid at best, with forecasters expecting annual wage growth of just 2.4% over 2021, more than a full percentage point less than the rate of wage growth consistent with inflation at the Fed’s target. Without sustained wage growth over 3%, it is difficult to see inflation even rising to the Fed’s target of 2%, let alone sustaining a rate above 3%, which most commentators and, importantly, the market would consider a blowout.

Table 1: Financial market movements: 4 - 11 February 2021

Source: Bloomberg