What’s the chance of inflation rearing its head again?

January 16, 2021

Lorenzo Forni

In terms of current market expectations, the markets are imputing a non-zero probability to an inflation rise above 2%

 

Remember stagflation? For those who have forgotten what it means, it refers to the situation of a high level of inflation which is accompanied by a recession or other weak economic activity. Stagflation characterized the 1970s; inflation was relatively high (in Italy between 1973 and 1984, inflation fluctuated between 10% and 20% per year) and the expectation was that it would remain high, despite high levels also of unemployment. Is this a situation that is likely to occur again?

Compared to the 1970s, the central banks of the main advanced countries are more independent and have a clear mandate to control inflation (in Italy, the 'divorce' of the Bank of Italy and the Treasury took place in 1981 and initiated a significant process of inflation containment which continued during the 1980s). As long as the central banks maintain their credibility, the common expectation is that were inflation to rise again, the central banks would intervene aggressively, and therefore, we should not worry about inflation

However, during summer 2020, the U.S. Federal Reserve adopted a new strategy defining that until unemployment reached a sufficiently low level interest rates would not be raised even if inflation were to exceed the 2% threshold. In other words, the Fed may not respond immediately to an increase in inflation of above 2%.

Traditionally, in macroeconomic models, inflation reaches the target level set by the central bank if the latter responds aggressively to expected increases in inflation (the so-called Taylor principle). The central bank’s reaction function is usually represented by a Taylor rule, where the chosen interest rate depends on the expected inflation and the output gap. When the output gap is close to zero, if the central bank raises the nominal interest rate less than the expected increase in inflation, the expected real interest rate will fall, thereby stimulating demand and further increasing inflation. When the output gap is negative, as it is currently, the central bank can respond less than proportionately and still achieve its inflation target. However, if its response is too weak, the equilibrium is indeterminate, i.e. inflation could rise indefinitely. In this situation, inflation expectations could rise in the immediate future even with still high levels of unemployment.

In terms of current market expectations, we would say the markets are imputing a non-zero probability to an inflation rise above 2%. Market expectations show that expected inflation rose from a low in spring 2020 to over 2% recently (figure below). Additionally, gold, a typical inflation-hedging asset, has appreciated significantly in recent months. Many traders consider Bitcoin to be a bit like gold. Since for technical reasons its supply is limited, and it has the potential to become an international reserve currency not tethered to a national authority, it too could protect against inflation. In short, market signals indicate that the probability of inflation above 2% is not zero.

 
Fig.1 – USA: 10 year breakeven inflation rate percentage values
Source: Federal Reserve
 

However, the current situation is different from the situation in the 1970s. First of all, expectations remain in the 2% range, thus close to central banks' targets. Second, the increased demand for gold and Bitcoin (net of the most recent declines) reflects a desire to protect against the risk of inflation not the expectation of high inflation. That is, agents are buying protection against the risk of high inflation which currently is not part of the baseline scenario but whose occurrence has a non-zero probability. However, we cannot rule out the possibility that inflation expectations could rise above 2% without the Fed intervening, thereby reducing expected real interest rates and supporting domestic demand, thus validating expectations of a higher inflation. 

There is a feeling that we are heading into an uncharted territory, and that the markets want to test the credibility of the major central banks following 20 years when their credibility was never questioned. 

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