After the global financial crisis of 2007-2008, long-term inflation expectations regularly dropped below central banks’ target levels due to a sluggish reflation process. Their efforts at sparking higher levels of inflation were held back by factors such as the shallow global economic recovery and after-effects from the multi decade rise in globalization. In order to address the risk of a “de-anchoring” of inflation expectations to the downside2 (see Exhibit 1), many central banks made adjustments to their monetary policy approach and related reaction functions – some clearly signalled and others more implicit. Some of their more reactive strategies have new names, such as the “flexible average inflation targeting” by the Federal Reserve or the “symmetric 2% inflation target” by the European Central Bank.
But the shift to these new reactive strategies raises the risk of a monetary policy error, particularly when it gets late in the economic cycle. If central banks are too late in addressing the risks that may de-anchor long-term inflation expectations to the upside, they could be forced into a more aggressive and disruptive tightening of monetary policy. This could upend parts of the global economy and make inflation more volatile. It would likely also affect financial markets. Rising long-term inflation uncertainty means investors would expect to be compensated accordingly, which would lead to higher inflation risk premia.
Exhibit 1: inflation expectations are on the rise
US inflation expectations/compensations (since 1999)
Source: Bloomberg, Philadelphia Fed, Cleveland Fed. Data as at 30 September 2021.
During the Covid-19 crisis, central banks around the world stepped up their unconventional stimulus measures, buying sovereign bonds at an unprecedented pace. This massive injection of central bank liquidity led to an unparalleled surge in global money supply (see Exhibit 2) that could fan consumer price inflation over time, in particular against the backdrop of rapidly shrinking output gaps3.
Critically, we don’t expect this situation to reverse anytime soon. There has been a steady rise in private and public indebtedness around the world, and ultra-accommodative monetary policy has kept the financial system afloat. But the system has also come to rely on this support, leading to what has been termed “fiscal and financial dominance” – an environment where central banks essentially do the bidding of their governments4. To be fair, higher coordination between the monetary policy of central banks and the fiscal policy of governments was necessary to contain the immediate economic fallout of the Covid-19 crisis. But maintaining this close link for too long would effectively prevent central banks from being independent. It could also introduce some form of modern monetary theory (MMT) – which broadly describes an environment where governments would end the era of independent monetary policy by taking back full control over the printing of their fiat currency to fund spending. In either case, the rising risk of MMT and fiscal/financial dominance should be reflected in higher long-term inflation expectations and rising inflation risk premia.
Exhibit 2: massive stimulus from central banks has pushed up asset prices
Central bank balance sheets vs global asset prices (since 2006)
Source: Bloomberg, Bank for International Settlement (BIS). Data as at 30 June 2021. Fed = Federal Reserve; ECB = European Central Bank; BoJ = Bank of Japan; BoE = Bank of England; SNB = Swiss National Bank; PBoC = People’s Bank of China. Global asset prices based on IMF Global House Price Index, BIS Property Price Statistics, FTSE World Broach Investment-Grade Bond Index and MSCI All Countries Equity Index (real estate, equities, bonds each 1/3 weight).
Globalisation had been a powerful disinflationary force in the two decades before the eruption of the financial crisis (see Exhibit 3), but it is now in retreat – an environment that some call “slowbalisation”. Growth in the volume of international trade has slowed and protectionism is on the rise. Reduced international access to cheap labour is putting upward pressure on wages, and eventually on prices. In addition, severe disruptions in global supply chains since the outbreak of the pandemic have triggered a wave of “re-shoring” activities in the corporate sector5. There have also been supply shortages in the UK as a consequence of Brexit. These examples illustrate how the longer-term trend of re-regionalisation and slowbalisation are structural issues that weigh on global economic growth while pushing consumer price inflation higher.
Exhibit 3: globalisation’s second wave seems to be ebbing
Global merchandise exports and global exports of goods and services (as a share of world GDP; 1827-2019)
Source: JH Fouquin, J Hugot (2016): "Two Centuries of Bilateral Trade and Gravity Data: 1827-2014", Ourworldindata, World Bank. Data as at December 2019.
For 30-plus years, the global workforce has been growing, reinforced by globalisation and access to cheap labour. Together, these forces provided a powerful tailwind that drove output up and inflation down, but this environment is coming to an end. A progressive ageing of the world population (see Exhibit 4), rising dependency ratios (where the working-age population is shrinking as a proportion of the total population) and slower growth in labour supply in the emerging world (particularly in China) may contribute to a return of inflation in the years ahead6. The interplay between these factors is complex, but consider that as the world grows older, there will be an increase in the “consuming” part of the population relative to the “productive” part of the population. All else equal, prices for goods and services would rise as demand outstrips supply.
Exhibit 4: demographic trends point to fewer workers, which could push up wages
Working-age population (1955-2100)
Source: United Nations. Data as at 2019.
In the last 40 years, there has been a persistent rise in wealth and income inequality around the world, contributing to a structural slowdown in consumer price inflation7. Fortunately, many governments are now making a concerted effort to reduce inequality. This could bring economic benefits and invite higher inflation – as seen in these examples:
- The shift towards “bigger government” in the United States and large parts of the industrialised world may lead to rising fiscal deficits, which could foster an inflationary environment of fiscal dominance.
- When lower-income households get a boost in discretionary income, they’re more likely to spend it – and this additional boost in spending can push up goods and services prices. (In contrast, middle- and higher-income households already have more discretionary income and are more likely to save, rather than spend, additional cash.) As a result, economic policies that help “redistribute” wealth and income could be inflationary (see Exhibit 5a).
- The combined effects of changing demographics and efforts to reduce inequality may already be showing up in a rising share of labour compensation (wages plus benefits) relative to GDP (see Exhibit 5b).
- In addition, we are observing voluntary increases of minimum wages by companies in order to attract staff.
Exhibit 5a: redistributionist policies are reducing economic inequality but could drive inflation higher
US wealth inequality vs consumer inflation (1962-2019)
Source: World Inequality Database, Bloomberg. Data as at 2019.
Exhibit 5b: labour share is rising
US labour compensation share (since 1960)
Source: Refinitiv Datastream, Allianz Global Investors. Data as at 4 October 2021.
While central banks in general exclude asset prices from their inflation mandate, real estate represents a grey zone. Owners’ occupied housing costs (as part of the “rent of shelter” component) affect consumer price inflation in several countries – including the United States, where rent of shelter accounts for 33% of the overall CPI basket and 42% of the core index (excluding food and energy). Within the next few quarters, the surging housing market (see Exhibit 6) is expected to drive up goods and services price inflation. (Higher home prices usually take around 12 to 18 months to spill over into consumer prices.) In this way, there is at least an indirect link to the spillover of monetary policy into asset markets.
Exhibit 6: surging housing prices aren’t yet been reflected in consumer price inflation
CPI – rent of shelter vs model (year-over-year change, 1985 – 2021)
Source: Bloomberg, Allianz Global Investors. Data as at 30 September 2021.
The continued rapid closure of output gaps (the difference between an economy’s actual and potential output; see Exhibit 7) means the global economy has rebounded well and unemployment should continue to fall. This is where the “Phillips curve” relationship comes into play, which states that along with lower unemployment comes higher prices. While the curve has flattened over the past 20 years, it still shows a link between low unemployment and higher services price inflation. Goods price inflation has behaved differently in recent decades, thanks to international forces helping to keep prices down. But goods prices may soon also begin to rise in a more sustainable way in light of “slowbalisation”, rising protectionism and the re-shoring of production – all of which are inflationary.
Exhibit 7: narrowing output gaps point to higher inflation
Output gaps in major developed economies (since 2000)
Source: OECD. Data as at May 2021.
Decarbonising the world economy to limit global warming and address climate change has become the preeminent challenge of our time. The importance of this task is undisputable, and “green growth” and similar investments may lead to higher economic output and lower inflation in the long run. Before we reach this point, however, the necessary transformation of the global economy may go hand in hand with less access to “cheap” energy, an increase in environment-related regulations, the obsolescence of “cheap” but dirty production processes and high volumes of stranded assets that are subject to write-downs. All of this means that the energy transition will likely be an inflationary one (see Exhibit 8). Yet it is also important to note that this inflationary pressure is a byproduct of internalising costs (at the product level) that have until recently been borne by other stakeholders.
For an example of how policy efforts to achieve long-term climate goals have an impact on inflation, consider two recent developments. The sharp rise in gas prices globally in 2021 to some extent reflect the increased demand for energy from gas-fired power plants, which emit fewer greenhouse gases than coal-powered ones8. In addition, local governments in China recently restricted coal-fired power generation to meet climate targets set by the central government. But this also caused disruptions in many industries, thereby exacerbating global supply-side constraints and adding to inflationary pressures.
Exhibit 8: the energy transition will likely push up near-term inflation
US, EU, China: change in inflation vs baseline for “net zero 2050” scenario
Source: Network for Greening the Financial System. Data as at 28 June 2021.