Is Inflation really ‘transitory’ or here to stay?

In 2021, the prices of goods and services rose more than they did in any year since 2008, leading to concerns about the potential impact on consumer spending, interest rates, and corporate margins. We think inflation will fall from currently high levels over the course of 2022. While the downtick in Inflation may be gradual and not abrupt, we believe the worst of the main drivers of Inflation may be behind us. Below are some thoughts on the major drivers of Inflation in 2021:

 

  • Supply-demand mismatches will likely resolve

    The spike in inflation is mostly a result of an exceptional surge in demand for goods that has outstripped the ability of supply to keep pace, exacerbated by pandemic-related supply chain disruptions. The result has been a combination of delivery delays, stock shortages, and price increases for certain goods. But while inflation has proven broader and longer-lasting than expected the prices of some of the goods and services most impacted by surging demand – such as used cars and apparel – have started to normalize.

 

  • Energy prices will likely stabilize

    Energy prices were exceedingly volatile in 2021 with Brent moving from trading just above the $50 mark at the start of the year to making multi-year highs of $86. We expect the base to shift to the 60s while the upside is likely to be capped around the 2021 highs. Stability in energy prices should help in easing the upward pressure on inflation.

 

  • Easing labour market frictions should help reduce wage pressure

    Labour shortages have been a challenge in some sectors as economies have reopened. This has contributed to record job vacancy rates and higher wage growth. Looking ahead, we expect more workers to return to the labour force and for quit rates to normalize, easing labour market pressures and stabilizing pay growth.

 

Back to ‘Normal’!! What are the downside risks to Growth?

2021 was about stratospheric growth rates as pent-up demand across sectors and easy liquidity meant consumer spending picked up swiftly. However,  any extrapolation of growth rates is likely to be out of sync with reality.

Growth rates have started ‘normalising’ as we approach the fag end of 2021. There are significant downside risks to growth as we step into the New Year. We highlight some of the potential risks below

 

  • Major central banks overreact to elevated inflation and tighten too early or too aggressively.
  • Sustained supply chain disruptions, elevated energy prices, and higher wage costs are passed through to consumer prices, leading to weaker demand.
  • Regulatory tightening in China inadvertently triggers a significant downturn in the property market, leading to substantially lower economic growth in the country and its main trading partners.
  • COVID-19 resurges due to virus mutations or signs of fading vaccine efficacy results in new economic restrictions & more supply chain disruptions.
  • US-China tensions reignite and impact global trade, or issues surrounding Iran’s nuclear program affect oil supplies and prices.

Central Bank Commentary: Stuck between a rock and a hard place

Central Banks are no strangers to goofing up policy decisions. After downplaying Inflation as ‘transitory’ for the best part of 2021, the Central Banks have finally woken up and now run the risk of jumping from the sublime to the ridiculous.

 

  • The Federal Reserve moved from not expecting any rate hikes in 2022 in the June meeting to expecting at least 3 rate hikes in 2022 after the Dec meeting. The Fed also dialed down its GDP projection for this year and raised its inflation expectation for 2021, 2022, and 2023. With Mar 2022 now being touted as a live meeting for a potential rate hike, investors need to be nimble going forward with respect to fine-tuning their portfolios to adjust to the changing dynamics with respect to Central Bank Policies.
  • European Central Bank followed suit and will discontinue net purchases under the Pandemic Emergency Purchase Program at the end of Mar 2022 but the Asset Purchase Program will continue at least through 2023. Vulnerable Sovereigns may have a hand in hindering ECB Policy normalization. Not only levels but the composition of spreads matter for the ECB. ECB can act on default risk premium and cap it. However, Systemic Risk Premium (Euro exit risk) is outside ECB’s sphere as it is driven by politics.
  • BoE has gone a step ahead and become the first major central bank to raise rates since the pandemic. The BoE pointed to the likelihood of more “modest tightening of monetary policy” over its three-year forecast period although inflation could prove weaker or stronger than expected. Investors rushed to fully price in another rise in Bank Rate to 0.5% by March 2022 and to 1% by September 2022.