Transatlantic inflation surge fuels economists’ fears of overheating

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A surge in the pace of price growth on both sides of the Atlantic has revived economists’ concerns about the risk of overheating, piling pressure on policymakers to consider a faster withdrawal of their unprecedented pandemic-era stimulus policies.

Data published earlier this week showed that US consumer prices rose by 5.4 per cent in June compared to a year earlier, the fastest pace since 2008 and a steeper increase than economists had predicted.

Then data published on Wednesday showed that UK inflation hit 2.5 per cent in the same period, its highest level since 2018.

Most economists and policymakers still consider the trend a transitory phenomenon tied to the lifting of pandemic-related restrictions — rather than a return to 1970s-style inflationary spirals. But many acknowledge that the likelihood of persistently higher inflation may be growing.

Price drivers

Both the US and the UK are experiencing price rises in part thanks to the unlocking of their economies as measures to control the spread of coronavirus are relaxed.

For example, in the US travel-related costs such as airfares, hotel fees and car rentals experienced significant price rises.

Both economies are also experiencing price growth in sectors that have suffered supply chain bottlenecks. In the US the index of previously owned cars and trucks increased by 45.2 per cent compared to June last year.

Energy costs have been rising sharply on the back of a jump in crude oil prices.

And economists noted a small but significant increase in rental prices in the US — an area of the economy where prices generally adjust more slowly but changes can prove longer-lasting.

Much of the inflationary dynamic in Britain echoes what has been unfolding in the US; UK inflation has been following US rates higher, but with a delay of a few months. 

Economists said this was likely to continue in the coming months. Paul Dales, chief UK economist at Capital Economics, said: “We think the gap between the two will shrink as inflation in the UK climbs to around 4 per cent by the end of the year.”

Jonathan Athow, the UK’s deputy national statistician, said the rise in prices was “widespread” but cited in particular “price increases for food and for second-hand cars where there are reports of increased demand”.

Line chart of Annual % change in consumer prices showing The pace of price growth picks up

Why not the eurozone?

Inflation has also picked up in the eurozone after several months in negative territory in 2020. However the increase has been more modest than in the US and UK; in June eurozone inflation dipped slightly to 1.9 per cent.

This may simply be because the 19-nation currency bloc is further behind both the US and UK in both its vaccination programme and in reopening its economy.

Economists expect that eurozone inflation will increase again in the second half of this year as its economic recovery gains momentum. For example Germany’s central bank expects its inflation rate to hit 4 per cent later this year, which would be its highest level for more than a decade.

There is also a technical factor which is expected to boost the headline calculation: German value added tax was temporarily cut in the second half of last year but that has now been reversed, a change which will affect the overall figure from July.

Spillovers?

The big question economists in all three places will face in the coming weeks and months is whether these pockets of price increases are sufficiently contained to avoid spilling over into the wider economy in an unhealthy way.

Some believe so far the danger is low.

Although the headline rate of US price growth in June was 0.9 per cent on a month-by month basis, Steven Englander, head of North American macro strategy at Standard Chartered, calculated the underlying rate — stripping out sectors including new and used vehicles, car rentals, hotels and airfares, as well as more volatile food and energy costs — would be just 0.22 per cent.

Megan Greene, a senior fellow at Harvard University’s Kennedy School of Government, was also cautious. “It’s really hard to have an inflation spiral without a wage spiral, and there are still very few indications that we might get a wage spiral,” she said. 

Policymakers’ dilemma

The pattern leaves central bankers and other economic policymakers on both sides of the Atlantic grappling with how to handle rising prices for the first time in decades. It is a sharp about-turn from their concerns about persistently low inflation in the aftermath of the 2008-09 financial crisis.

If they underestimate the persistence of price growth and dismiss the evidence to date as ephemeral, they risk having to raise interest rates much more abruptly later in a bid to catch up.

If inflation becomes entrenched, policymakers may even have to take fiscal action to cool their economies.

On the other hand, if they act too quickly to withdraw pandemic-era economic support measures, it could jeopardise the recovery at a delicate stage.

That is a particular danger given the growing spread of coronavirus variants across many parts of the world.

So far the US Federal Reserve and the Bank of England have stuck to their views that inflation will be transient, although they have both indicated that policy might tighten earlier than previously thought if the data justifies it.

Both Germany’s Bundesbank and the European Central Bank also expect eurozone price growth to fade next year. The ECB forecasts inflation will fall below its recently revised 2 per cent target in 2022, and reach 1.4 per cent in 2023.

Christine Lagarde, ECB president, told the Financial Times on Sunday that the bank’s new strategy is “intended to signal that we will not prematurely tighten” by tolerating above-target inflation for longer. But Bundesbank president Jens Weidmann has called for bond purchases to slow.

However, central bankers’ repeated failure to foresee the economic trajectory is making some analysts more nervous.

“Given the long-run outlook for persistent inflation modestly above central bank targets in the UK and the US, a stronger than expected near-term inflation impulse could turn into a sustained trend,” said Kallum Pickering, an economist at Berenberg Bank.

“For now, this risk remains modest. However, the warning from history is clear: all periods of high sustained inflation appear temporary at first.”

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