Those who heed current consensus forecasts of persistently low price growth could be in for a rude awakening. ZURICH — Current forecasts by many banks, central banks, and other institutions suggest that inflation will not be a problem in the foreseeable future. The International Monetary Fund, for example, expects global inflation to remain subdued until the end of its forecast horizon in 2025. Economic models have long been notoriously inaccurate in predicting inflation, and COVID-19 has further complicated the challenge.
While economic forecasters calibrate their models using data from the last 50 years to explain and predict economic trends, today’s economic conditions have no precedent in that period. Today’s low inflation forecasts are thus no guarantee that inflation will actually remain low. Even without additional inflationary pressure, reported inflation rates will rise significantly in the first five months of 2021. By May, UBS expects year-on-year inflation to rise above 3% in the United States and toward 2% in the eurozone, largely owing to the low base in the first half of 2020, when pandemic-related lockdowns began.
Many argue that the COVID-19 crisis is deflationary, because pandemic-mitigation measures have affected aggregate demand more adversely than aggregate supply. Many people’s actual consumption baskets have thus become more expensive than the basket statistical authorities use to calculate inflation. So, true inflation rates are currently often higher than the official figures, as reports have confirmed. Once governments lift mobility restrictions, services inflation also may increase if reduced capacity — as a result of permanent closures of restaurants and hotels, for example, or airline layoffs — are insufficient to meet demand.
The unprecedented fiscal and monetary expansion in response to COVID-19 may pose an even greater inflation risk. Previous episodes of excessive government debt almost always ended with high inflation. Inflation caused by a loss of confidence can emerge quickly and in some cases at a time of underemployment, without a preceding wage-price spiral. Although expansionary monetary policy after the 2008 global financial crisis did not lead to increasing inflation, this is no guarantee that price growth will remain low this time.
Demographic shifts, increasing protectionism, and the US Federal Reserve’s de facto increase last year of its 2% inflation target are among other factors that could lead to higher inflation in the longer term. Although these structural factors are unlikely to trigger a surge in price growth in the short term, they could still facilitate it. A sharp rise in inflation could have devastating consequences. This has often resulted in very high rates of inflation, accompanied by large losses in the real value of most asset classes and political and social upheaval.
With inflation rates highly correlated internationally, higher inflation in the dollar area would accelerate price growth worldwide. Too many are underestimating the risk of a rise in inflation, and sanguine model-based forecasts do nothing to alleviate my fears. Monetary and fiscal policymakers, as well as savers and investors, should not allow themselves to be caught out. In 2014, former Fed Chair Alan Greenspan predicted that inflation would eventually have to rise, calling the Fed’s balance sheet «a pile of tinder.» The pandemic could well be the lightning strike that ignites it.
Source: Axel A. Weber | Project Syndicate
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