The resurgence of inflation began as one of the great economic surprises in early 2021. The strength with which prices have re-emerged in some regions and their persistence has been such that the surprise has become a threat . Inflation is above the target of central banks in the US, the Eurozone, the United Kingdom, Canada … However, not all economies suffer the same time of inflation, nor do they present the same vulnerabilities. Bank of America Merrill Lynch (BofAML) has produced an inflation map with different parameters that reveals the economies that are most at risk of persistent and damaging inflation.
The parameters used are the underlying inflation (it does not weight raw food or energy), the spread or the differential of current interest rates with which the famous Taylor rule dictates , the production gap or output gap , surprises about the inflation and the increase / reduction of the structural public deficit until 2022. Exceeding these parameters in the ‘wrong’ direction increases the risk of suffering high and persistent inflation that could eventually force central banks to intervene aggressively damaging the economy and generating a shock in the markets, warn BofAML analysts.
Among the ten countries / regions analyzed, the US inflation risk stands out above all. It is followed by New Zealand, the United Kingdom and Canada, where inflation is also high and rates should be much higher according to the Taylor Rule. At the other extreme are Japan, Norway, Switzerland and Australia, while Sweden and the Eurozone are in the middle. The case of the US is especially striking because practically all its parameters present a high inflationary risk.
“The market has been very surprised by the latest inflation data in the US (6.2% per year, the highest rate in 30 years) . The US economy faces inflationary risks that go beyond temporary base effects,” he warns the BofAML report.
These experts argue that the US economic recovery is the most advanced within the G10 nations, despite this state of ‘maturity’ of the recovery, the Federal Reserve and the Government have continued to press the accelerator of expansionary monetary and fiscal policies . “Imbalances in the US labor market have been deepening. Wage pressures are intensifying , with the employment cost index and unit labor costs rising in the third quarter.” Right now, wages are growing faster than productivity, which on the one hand can feed back inflationary tensions (each unit produced costs more) and weighs down the competitiveness of the economy in relative terms (with the rest of the world).
The heat map that reveals inflationary risks
To all this must be added that “the transitory effects that have to do with the supply bottlenecks of the pandemic are proving to be persistent. Structural and global trends are also important, such as the reduction of dependence on supply chains global and low investment in fossil fuels. Surprises in global and US inflation are at record highs, “the report said.
Core inflation in the US is at 4.6%, a rate of change that has not been seen since 1991. In addition, a growing range of goods and services are beginning to register notable price increases, which shows that the Inflation is spreading as production costs (higher wages, scarce raw materials, energy bills …) are transferred to the consumer basket. Consumption of goods in the US has shattered all forecasts, generating demand inflation that in turn joins global supply inflation.
With these data it seems ‘logical’ that the interest rates managed by the Fed were at a higher level to avoid an overheating of the economy. The Taylor Rule, which is calculated taking into account inflation, the natural or neutral interest rate (the one consistent with a situation of full employment and controlled inflation) and the natural unemployment rate, reveals that the federal funds of the Fed should be above 6% so as not to fall behind the curve. However, the Fed maintains rates between 0 and 0.25%, increasing the risk of inflation.
Interest rates should be much higher with Taylor’s Rule
Added to all of the above is a structural deficit (it does not take into account the impact of the economic cycle on income and expenses) that will remain very high in the US until 2022, given that the Government intends to launch an ambitious infrastructure plan. The IMF estimates that in 2022 the structural deficit will continue to exceed 8% of GDP. These expenses and this deficit will push inflation up, since it will increase the consumption of materials and the demand for workers in a labor market in which there are already a record number of unfilled vacancies.
Lastly, the US is the country with the largest positive gap with its potential GDP ( positive output gap ). This means that the economy is operating above its potential capacity (taking into account that the factors of production are relatively rigid). Continuing to stimulate an economy in which its productive factors are already operating at the limit can only lead to a greater increase in prices in the short term. The Fed should act to reduce this risk of overheating.
“With inflation so high and the market already discounting two rate hikes for next year, we don’t think the Fed can afford to wait long this time. We are concerned that if they finally wait longer they might have to make an even faster adjustment. , increasing the risk of a market shock . The Fed will have to face the dilemma of fighting inflation versus supporting risk assets. With inflation on the rise, in our opinion, they cannot do both, “say the economist. by BofAML.
At the other end of the US, the most prominent case is that of Japan , which shows an intense green in all the criteria of the heat map except for inflation surprises, which appears in yellow. With a slow economic recovery in the face of the still palpable effect of the COVID restrictions – activity contracted sharply in the third quarter – the Japanese country faces much less inflationary risks than its G10 partners. Japan is immersed in full policy change after Fumio Kishida came to power , tending to improve social welfare policies and preparing a new multimillion-dollar package for economic recovery .
A tepid risk for the Eurozone
Within the G10 heat map, the situation in the Eurozone does not seem so pressing when it comes to inflation. Reviewing the criteria of the BofAML analysts, the one that attracts the most attention is the output gap . To its regret, the euro zone has the largest G10 gap between real GDP and potential GDP, sinking more than 2.5% into negative territory. This disadvantage, the materialization of a slow recovery after the pandemic, serves as an anchor for the region against inflationary fears and therefore appears bright green on the heat map.
Another indicator that appears in green for the Eurozone is that of the evolution of the structural deficit for 2022. Unlike in pairs such as the US, New Zealand or the United Kingdom, in the core of the Old Continent its reduction will be more substantial. Reviewing the latest data from the IMF, the Eurozone will go from a structural deficit of 5.9% in 2021 to 3.1% next year. Almost three cut points only improved by the forecasts for Canada (from -6.6% to -2.7%) and Japan (from -8% to -3.6%).
With a yellowish tone that coincides with the average term in which the Eurozone is situated within the G10 in the global indicators, that of core inflation appears. 2.1% of the region in October is in a middle ground within the ranking, with the US, Canada and the United Kingdom in higher figures. The differential between current rates and those produced by the aforementioned Taylor rule calculation appears somewhat more orange. Applying this formula, the Eurozone should have rates of 5.20%, with the spread with the ECB deposit rate (-0.5%) at 570 basis points.
The darkest indicator for the euro countries on the map is that of surprises due to the inflation data . Despite the ‘calm’ of the other indicators, the latest data ( 4.1% year-on-year of general inflation in October ) have supposed highs not seen since 2008 that have somewhat exceeded the estimates of the experts. In this sense, only in New Zealand have the high inflation rates caused greater surprise, with the rates registered in the United States and the United Kingdom being somewhat more ‘expected’.
“Despite the recent rise in inflation in the Eurozone, we believe that the President of the European Central Bank (ECB) Lagarde is correct in underlining that the ECB still does not meet its inflation target and that it is highly unlikely that the measures will be met. conditions for a rate hike in 2022, “say analysts at BofAML, who expect core inflation in the euro zone to return to well below 2% next year and remain so for the next three years. They also expect headline inflation to remain above 2% next year, but to fall below 2% again in 2023.
The bank’s economists believe that this breach of the ECB’s ‘new’ objective will be telegraphed to the rate and stimulus policy. “While the market is appreciating that the ECB begins to raise rates next year, we do not expect it to do so, not next year or the next, at least. Furthermore, we expect the ECB to continue with the QE (APP ) after the PEPP ends in March , a decision that should be announced during the December meeting, “they say.
An opinion shared by analysts at Oxford Economics. “We see little evidence that the outlook for core inflation in the Eurozone has changed a lot over the past few months. In fact, there is a high probability that low inflation will return next year . Hence, speculation about rising The ECB at the end of 2022 seems out of place, “says Oliver Rakau, the firm’s chief economist for Germany. “We forecast that inflation will decelerate rapidly next year, heading towards 1% in the fourth quarter of 2022, with an average of 2% in 2022 and only 1.2% in 2023,” he says.
“Rising durable goods prices could continue to prop up underlying inflation in the short term. But unlike the US, durable goods spending in Europe is weak, so supply jams are more to blame than demand. and the relaxation of prices of raw materials and bottlenecks should cause prices to return to their downward trend of the last decade , “strutting Rakau.
Similarly, the economist sees no signs of an emerging spiral in prices and wages and rules out that “the recovery is strong enough to allow companies to further fatten profit margins , so inflation will slow down as pressure on import prices will decrease “. Overall, he concludes, “we maintain our view that core inflation will remain contained for the next several years, unless growth is stronger or commodity prices are higher than expected.”