Back in July 2019, the theme of this column was lowflation — the inability of many advanced economy central banks to achieve an inflation rate high enough to meet their respective inflation targets. Globalisation, automation and institutional changes, both in labour markets and around the price-setting activities of firms, had delivered persistent disinflationary pressures. Inflation-targeting central banks such as the Reserve Bank of Australia had, it seemed, been almost too successful in influencing inflation expectations, convincing their publics that inflation would be permanently lower. While that column was careful to note that this low-inflation regime faced risks — flagging concerns around protectionism and the burden of global debt — it also judged it was difficult to see it unravel in the near term.

That was then. Price rises are now back in the news, with the popularity of Google searches for “inflation” higher than they’ve been for more than a decade.

More significantly, earlier this year financial markets began to price in higher inflation expectations — a “reflation trade” — that saw steepening yield curves as yields on longer-dated government bonds climb while inflation break-even rates rose to multi-year highs. (The latter are calculated as the difference between the yields on nominal bonds and inflation-linked bonds of the same maturity.) Buoyed by hopes for a successful vaccine rollout and signs of a global economic recovery gaining traction around the start of this year, inflationary concerns received further impetus from the Biden administration’s success in delivering the huge US$1.9 trillion American Rescue Plan.

Inflation returns

The first quarter of 2021 has also brought genuine inflationary pressures: Recent months have seen higher commodity prices, including significant rises in the price of metals such as copper, iron ore and nickel and a run-up in food prices including soybeans in a “return of the old economy” upswing.

Supply problems in several key markets, including shipping and semiconductors, have manifested in a mix of higher prices and production delays. That’s not to mention the giant Ever Given, a stranded 400m-long container ship, blocking the Suez Canal and disrupting shipping traffic, and therefore supply chains, for a week in late March. According to data from Lloyd’s List, the blockage was holding up an estimated US$9.6b of goods each day.

Disruptions to global supply chains more generally have seen recent purchasing managers indices (PMIs) report input prices rising at their fastest pace in a decade. A range of one-off adjustments to administered prices, the impact of the reopening of previously closed sectors of the economy and changes in indirect taxes are also contributing to a range of price rises.

Yet for all the noise, and despite a modest uptick in January this year, headline inflation rates across the OECD remain very low by historical standards.

In the short term

The key question is whether what currently looks mostly like short-term inflationary pressures — even once supplemented by the fiscal largesse of the American Recovery Plan — will deliver general price increases large enough and sustained enough to return us to a higher inflation world. There are reasonable grounds for scepticism.

First, there is still a substantial amount of spare capacity in the world economy including significant slack — unemployment and underemployment — in global labour markets. While that remains the case, it is difficult to see the emergence of a self-reinforcing round of wage-price increases. Especially since several of the structural factors that have capped wage growth in recent years — international competition, automation and the big shift in relative labour market power — remain in place, albeit somewhat modified by the state of the post-pandemic landscape.

Second, central banks retain the ability to respond to any significant inflationary breakout. True, interest rate policy is constrained, but it is constrained in an asymmetric way. Policy is grappling with an effective lower bound for policy rates and the flipside of that constraint is ample room for rate increases, should they be needed. A sustained inflationary outbreak would therefore require a similarly sustained series of policy mistakes by central bankers. Or, put differently, it would require the prolonged pursuit of a policy of benign neglect that ended up delivering unintended malign consequences. There’s also evidence that markets share this broad assessment. A look at break-even inflation rates shows that shorter maturity rates (two- and five-year rates) tend to be higher than 10-year rates, suggesting markets think any short-term inflationary pressures will be contained into the medium-term. Moreover, while the market-implied inflation rates may look high by recent standards, in absolute terms, they remain modest.

So, we shouldn’t worry about inflation?

Not quite. That 2019 column warned that a potential source of inflation risk was an economic regime shift significant enough to change inflationary expectations and inflation dynamics. And it’s possible to identify several plausible building blocks for such a change.

First, some major central banks have adjusted their approach to monetary policy in ways that effectively downgrade the relative weight they place on offsetting the risk of future inflation in favour of a greater emphasis on lowering current unemployment. All else being equal, they are likely to be slower to tighten policy in response to incipient inflationary pressures than previously.

Second, there has been a parallel global shift in approaches to fiscal policy, seen most radically in the Biden package, but also visible in the UK government’s rebalancing of fiscal priorities and Canberra’s own decision to tie budget repair to the state of the labour market. Claims that Modern Monetary Theory, with its downplaying of the importance of debt and deficits, has won the fiscal battle of ideas go too far. But there is an element of truth that captures a changing fiscal orthodoxy.

Thirdly, the political backlash against post-GFC fiscal austerity, anxiety regarding populism and inequality, and the radical nature of the policies governments adopted during the pandemic have contributed to a rebalancing in societal and political preferences.

Finally, it’s important to remember that the economics of the pandemic to date have already overturned expectations in several significant ways, cautioning against any excess confidence in contemporary economic predictions.

None of this makes a return to a world of higher inflation in any way inevitable, but the risk is worth monitoring.