A useful term, base effects, helps explain dramatic increases in GDP and other barometers of activity as economies recover from the COVID-19 pandemic. The term places such indicators in the context of a recent anomaly—in this case the dark, early stages of the pandemic that depressed global economic activity.
Base effects help mask the reality that activity hasn’t yet reached pre-pandemic levels in most of the world, that labor markets are still notably lagging despite recent strength in some places, and that the threat from the disease itself remains high, especially in emerging markets. These amplified comparisons to previous weak numbers portray a U.S. economy going gangbusters. Inflation is the next indicator to be roiled in this way.
It’s quite possible that base effects, as well as supply-and-demand imbalances brought about by the pandemic, could help propel the U.S. Consumer Price Index (CPI) toward 4% or higher in May and core CPI, which excludes volatile food and energy prices, toward 3%. All else being equal, we’d expect inflation to fall back toward trend levels as base effects and a shortfall in supply fade out naturally.
But inflation, once it takes hold in consumers’ minds, has a particular habit of engendering more inflation. Beyond that, all else is not equal.
A real threat of persistent higher inflation
Sources: Vanguard assessment as of April 13, 2021, using data from the U.S. Bureau of Labor Statistics, Federal Reserve Economic Data, Federal Reserve Bank of Atlanta, Federal Reserve Bank of New York, and the U.S. Congressional Budget Office.
With the tepid recovery from the 2008 global financial crisis still fresh in mind, policymakers around the world have embraced fiscal and monetary policies as aggressive and accommodative as we’ve seen since World War II. Base effects will no doubt dissipate, and an inflation scare that we expect to play out in coming months will likely ease. But the threat of persistent higher inflation is real.
We’re watching for the extent to which any ramp-up in U.S. fiscal spending beyond the $1.9 trillion American Rescue Plan Act (ARPA), enacted in March, may influence inflation psychology. Our enhanced inflation model—the subject of forthcoming Vanguard research—investigates, among other things, the degree to which inflation expectations can drive actual inflation.
That inflation expectations could have a self-fulfilling nature shouldn’t come as a surprise. As individuals and businesses expect to pay higher prices, they expect to be paid more themselves, through increased wages and price hikes on goods and services.
Fears of a self-perpetuating wage-price spiral are understandable, given the experience of older investors with runaway inflation in the 1970s. But many of the factors that have limited inflation, notably technology and globalization, remain in force. And we expect central banks that will welcome a degree of inflation after a decade of ultra-low interest rates will also remain vigilant about its potentially harmful effects.
Higher core inflation under most scenarios
Notes: Our scenarios are based on the following assumptions: downside—net neutral additional spending (any additional spending offset by revenues), marginal increase in inflation expectations; baseline—$500 billion in fiscal spending above what has already been approved, a 10-basis-point increase in inflation expectations, and 7% GDP growth in 2021; upside—$1.5 trillion in fiscal spending above what has already been approved, a 20-basis-point increase in inflation expectations, and 7% GDP growth in 2021; “go big”—$3 trillion in fiscal spending above what has already been approved, a 50-basis-point increase in inflation expectations, and GDP growth above 7% in 2021. The “go big” scenario forecast dips below the upside forecast early in 2022 because of stronger base effects associated with the “go big” scenario in 2021.
Sources: Vanguard assessment as of April 30, 2021, using data from the U.S. Bureau of Labor Statistics, Federal Reserve Economic Data, Federal Reserve Bank of Atlanta, Federal Reserve Bank of New York, and the U.S. Congressional Budget Office.
Our model tested scenarios for fiscal spending, growth, and inflation expectations. In our baseline scenario of $500 billion in fiscal spending (above the ARPA), a 10-basis-point increase in inflation expectations, and 7% GDP growth in 2021, core CPI would rise to 2.6% by the end of 2022.1 Our “go big” scenario of an additional $3 trillion in fiscal spending, a 50-basis-point increase in inflation expectations, and even greater growth would see core CPI increasing to 3.0% in the same period. Both scenarios assume the Federal Reserve doesn’t raise its federal funds rate target before 2023.
If we’re right, that would mean a breach of 2% core inflation on a sustained basis starting around a year from now. And though we don’t anticipate a return to the runaway inflation of the 1970s, we do see risks modestly to the upside the further out we look.
A sustained rise in inflation would eventually mean the Federal Reserve raising interest rates from near zero. (Vanguard economists Andrew Patterson and Adam Schickling recently discussed the conditions under which the Fed will likely raise rates.)
With rates having been so low for so long, adjusting to this new reality will take time. But our current low-rate environment constrains the prospects of longer-term portfolio returns, so escaping it may ultimately be good news for investors.
I’d like to thank Vanguard economists Asawari Sathe and Max Wieland for their invaluable contributions to this commentary.
1 Our model accounts for annual fiscal spending on a net, or unfunded, basis. The extent to which tax increases might fund spending could change our growth assumptions and limit our model’s inflation forecasts. A basis point is one-hundredth of a percentage point.
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