Usually during recovery phases following a recession, it takes quite some time before inflationary pressures begin to appear. For investors, this respite is very good news. They can welcome the return to growth, which favours corporate earnings, without fearing monetary tightening.

Yet the 2020 recession was atypical, and the recovery is proving to be just as unusual. Growth should receive abnormally strong support in the quarters ahead. The United States has already embarked on this path and the Eurozone will follow in its wake as soon as health restrictions are gradually lifted. Yet demand is recovering so strongly that supply cannot keep pace, despite the rebound in capacity utilisation rates. Consequently, more and more sectors, in both industry and services, are facing longer delays and higher input prices. In the United States, even though the job market is still in shock due to the health crisis – millions of jobs must still be created before employment returns to pre-pandemic levels – many companies are complaining that they cannot find the necessary workers, in part because some of those who lost their jobs have switched to other lines of business.

The recent US inflation figure, however, served as a wake-up call. What if price acceleration was not temporary, contrary to the reassuring comments of the Fed’s monetary policy committee members? According to these experts, economic supply will adjust and production capacity will be created – now that the key drivers of corporate investment have come together – while the upturn in demand will slow once the euphoria of lifting health restrictions has past. It is also hard to determine the exact intensity of demand: fearing that shipment periods may be too long, companies could be tempted to order more than needed while reserving the option to cancel part of their orders subsequently. If this is the case, order books may be giving an overly positive picture of reality. Another crucial factor in the Federal Reserve’s analysis is that inflation expectations are still firmly anchored, even though they seem to be rising somewhat for both households and companies. Inflation expectations play a key role because they influence the setting of prices as well as wage negotiations.

Yet it is the financial markets that are worrying the most about inflation. In the United States, breakeven inflation – the yield spread between nominal bonds and that of inflation-linked bonds of the same maturity – has already increased by 150 basis points after hitting a low in spring 2020. It is now in the higher end of the range since the late 1990s. In the Eurozone, breakeven inflation has increased by 100 basis points using German Bunds as the benchmark. On both sides of the Atlantic, the increase in breakeven inflation reflects fears that we might be in for a nasty surprise concerning inflation, which could rise higher or last longer than currently expected.

The latter scenario would put investors in a very uncomfortable position by raising doubts about the temporary nature of the recent spike in inflation. This would inevitably feed expectations of monetary tightening. In the United States, Jerome Powell clearly stated that if reality proves to be different from the Fed’s expectations, then the Fed wouldn’t hesitate to draw the necessary conclusions about monetary policy. That is exactly what we should hope they would do in such a situation. When central banks do not show sufficient determination, they lose credibility, which eventually drives up long-term rates. It would also bring back the bad memories of the 1970s, when the Federal Reserve lost complete control over inflation because it was afraid to tighten policy sufficiently. It was not until Paul Volcker took the helm that the Fed pursued a rigorous anti-inflationary monetary policy, at the price of two successive recessions in the early 1980s.

Despite fears of excessively high inflation over the long term, our central scenario still calls for the pace of price increases to peak before gradually slowing until it returns to its underlying upward trend. Yet the markets may stay riveted to an alternative scenario, one in which inflation holds persistently above target and is more volatile, moving in line with economic data and the ensuing declarations by central bankers. The authorities will be hard pressed to convince investors that they understand inflationary dynamics better than the market.


Reproduced with the kind authorization of L’AGEFI