Forecasting inflation is like forecasting exchange rates. In both cases, economists must go out on a limb. Given the number of factors that come into play, making predictions about inflation and exchange rates leads more often to fiasco than to kudos.
Let’s consider a recent, telling example. High inflation expectations were rife in the months following the 2008 crisis, as the world’s most powerful central banks embarked upon a mind-boggling expansion of money supply which they used to buy financial assets. Most economists cautioned at the time that printing such inordinate amounts of money was likely to drive up inflation. Well, not only has that risk failed to materialise over the past ten years, but we got the opposite. Inadequate inflation and anaemic GDP growth have become enduring challenges that are hampering overleveraged economies and companies, making it impossible for the latter to raise prices.
In the wake of 2008, the bulk of the money printed never made its way into the real economy. This is partly because banks were in no mood to take the risk of granting loans to clients. In addition, consumers and businesses similarly felt they should play it safe. So, the extra liquidity injected by central banks simply didn’t translate into higher consumer spending or capital investment. Most of it never made it beyond the inner workings of the financial system. The upshot was that prices for stocks and bonds climbed to dizzying heights, whereas those for consumer goods barely budged. In short, investors have been the big winners in these past twelve years.
Today, the spectre of resurgent inflation is being raised once again and the case for such forecasts is basically beyond dispute in the short term. Year-on-year calculations are almost guaranteed to indicate that consumer prices will be higher in the coming weeks than they were in spring 2020 when most people were confined indoors.
The upward trend in prices could become more pronounced and lasting, because while consumer demand is poised to pick up, supply is still being constrained by all the disruptions to production that have occurred in the past year. The global surge over the last twelve months in prices for commodities like copper and for semiconductors offers ample proof of just how decisively the iron law of supply and demand dictates prices for goods and services. In the United States, where the economy is mostly re-opened, the consumer price index for April has exceeded even the more upbeat forecasts from economists.
But the short term isn’t the most relevant time frame. For what if, after greatly overestimating the risk of inflation at the start of the previous decade, economists were now underestimating it for the decade ahead? This is the key question, because there is a radical difference between the crisis-fighting measures adopted in 2008 and those that have been deployed since 2020.
This time round, governments have learnt from the “mistake” they made in 2009. Policy makers have been conscious not to simply buoy up the cost of financial assets, instead of the broad economy. Financial support has been directed towards individuals and businesses, in the form of benefits, guaranteed loans, grants and public investment. Central banks have not been going it alone. As a result, there are good grounds to hope the disinflation of the past few decades, which led to an uninterrupted decline in interest rates, may be on its way out.
In the short term, it is impossible to know for sure. Events of the past decade show that overleveraging is a formidable obstacle to any increase in inflation and interest rates. There is much less danger of inflation shooting up in Europe. Large-scale underemployment, structural impediments to growth and the region’s more limited recovery plans make a fully-fledged shift in the inflation regime seem less likely.
Rising prices are still bound to accompany the re-opening of economies and disruptions to supply chains could make a big difference to investors over the next few months. Economists’ standard models are not equipped to come up with a reliable inflation forecast in such an unpredictable environment. The risk of resurgent inflation alone is enough to make investors more cautious, because if it is materialised, it would take a large bite out of the savings they have ploughed into low-yielding bonds for so many years.