Your complete guide to inflation outlook in 2021 (Part 2)
What could cause high inflation in 2021? Too much demand met by too little supply; surging commodity prices; supply chain constraints; dollar depreciation; money printing; average inflation targeting.
In Part 1 of this long analysis, we explained how inflation is determined by a basket of goods and services. Covid-19 caused surges in prices for certain goods, but we still see no signs of broad-based inflation.
Today we provide a brief overview of the arguments for higher inflation in 2021, which has been causing fierce debates between policymakers and investors.
What could cause high inflation in 2021?
1. Too much demand, too little supply
Businesses and suppliers in certain sectors would have greater pricing power if there is sufficient demand in post-Covid recovery. This point was made by former NY Fed President Bill Dudely in his recent podcast with Bloomberg. Some major sectors, like leisure and hospitality, have thinned down due to absent demand and financial distress during the pandemic. A resurgence in demand for these services could be met by a smaller number of businesses, who could take advantage of a less competitive landscape to raise prices.
Whether we’ll see great demand overwhelming supply is perhaps one of the most widely debated questions today. Fed Chair Jerome Powell addressed this issue during his press conference on 12/16/2020. The transcript below is selected out and edited by Apollo chief economist Torsten Slok for clarity:
QUESTION: Thank you, Mr. Chairman. Some forecasters have suggested that there is a lot of pent-up demand for travel and entertainment and services and that might stop being pent up in a hurry if we do get to a point where the vaccine is widely distributed. And that the beaten down service sector might have trouble meeting that demand in a hurry. How might that affect inflation in your mind? And would that be just a transient problem or something that might warrant closer scrutiny?
POWELL: So that has all the markings of a transient increase in the price level. You can imagine that as people really wanna travel again, let's say that airfares go up. But what inflation is is a process whereby they go up year upon year upon year upon year. And given the inflation dynamics that we've had over the last several decades, just a single sort of price level increase has not resulted in ongoing price level increases.
That was the problem back in the 1970s––it was the combination of two things. One, when unemployment went down and resources got tight prices started going up. But the second problem was that that increase was persistent. There was a level of persistence so if prices went up six percent this year they’d go up six percent next year because people internalize that they can raise prices and that it's okay to pay prices that are going up at that rate.
So that was the inflation dynamics of that era. Those dynamics are not in place anymore. The connection between low unemployment or other resource utilization and inflation is so much weaker than it was. It's still there but it’s a faint heartbeat compared to what it was. And the persistence of inflation if oil prices go up and then––that'll send a temporary shock through the economy. The persistence of that into inflation over time is just not there.
So what you describe may happen and of course we would watch it very carefully. We understand that we will always be learning new things from the economy about how it will behave in certain cases. But I would expect that that would be a one-time price increase rather than an increase in underlying inflation that would be persistent.
QUESTION: So––so not the kind of thing that the Fed would––would be trigger happy to––to––
POWELL: ––No––
Chair Powell provided some great reasoning as to why the inflation dynamics today are very different from that of the hyperinflation era in the 1970s – namely that even if a price level shock were to happen due to pent-up demand, it will likely be a transitory, temporary shock. We will explain more in Part 3 why inflation might continued to be muffled in 2021.
2. Surging commodity prices
Rising commodity prices coupled with Covid trade risk could cause “cost-push inflation.” If the input costs for raw materials go up, it will force the end products to be more expensive.
Prices for used cars and lumber have already skyrocketed during the pandemic, likewise with the price for cotton due to poor weather conditions. OPEC recently cut its daily output of oil barrels by 65,000, which has quickly pushed oil prices above $50/barrel for the first time since the pandemic began.
3. Supply chain constraints
In general, anything that could lead to higher production costs for goods could lead to higher inflation. Covid related risks could lead to various forms of supply chain restrictions. For example, the U.S. could restrict trade from Europe if their virus situation worsens or vice versa. If Apple is forced to move its factories away from China, or if Nike couldn’t get its shoes from Vietnam in time, these supply chain constraints could have profound effects on domestic inflation in the U.S.
4. Dollar depreciation
A weakening dollar could be a primary determinant of high inflation in the near-term. The dollar has depreciated rapidly since around May in the pandemic. With a weaker dollar, people overseas can purchase U.S. goods more cheaply with their local currencies. This could lead to higher demand for U.S. goods and cause domestic prices to quickly rise.
Likewise, a weaker dollar could also increase the costs of foreign goods, thus pushing up import prices and leading to higher domestic price levels.
See the dollar depreciation below of the WSJ Dollar Index, which measures the exchange rate of the dollar against a basket of other major currencies:
The dollar’s ongoing depreciation can mostly likely be attributed to a combination of low rates and low economic growth prospects that have lowered the global demand for the dollar, relative to other currencies.
5. Continued increase in money supply
A rapid growth in the money supply could boost inflation expectations. When the Fed purchases assets to support market functions, more money is injected into the economy, hence we say that the “money stock” or “money supply” have gone up.
The Fed’s substantial response to the pandemic in March has caused a massive spike in the U.S. money supply. The chart below shows the growth in M1 money stock (the liquid form of money, such as physical currency and demand deposits, not including savings accounts or financial assets) since 2019, which has gone more than doubled from about $3.6 to $6.8 trillion in 2020:
The Quantity Theory of Money (QTM) asserts that an increase in the money supply can raise price levels if the supply is growing at a faster rate than real output. This is not an unrealistic possibility considering how the world economic growth has slowed down dramatically.
However, Keynesian economists would argue the money supply itself is not a major determinant of inflation, and they’d point to demand-pull and cost-push inflation as the two main phenomena to consider.
We also haven’t seen this relationship play out for many years – the Fed has been “printing money” since the 2008 financial crisis, but the Fed has failed to reach the 2% inflation target in over 10 years. This is a worry, but it’s not an imminent risk on people’s minds.
6. Fed’s new “average inflation targeting” framework
We will discuss this idea in greater detail in another post, with more technical explanations of what the new framework is.
To be continued…
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What an intriguing read!