The inflation conundrum

When all you got is a hammer...

From Tuomas Malinen’s Forecasting Newsletter.

Issues contributed:

• The monetary shock, the main driver of inflation in the U.S., has a long way to go.

• Inflation picture in the Eurozone remains very difficult.

• The policy mistakes that led inflation to spike are not easy to revert.

Inflation has slowed notably during the past few months. In the U.S. the (annualized) Consumer Price Index (CPI) rose by 4.9% in April and in the Eurozone the Harmonized Index of Consumer Prices (HICP) rose by 7.0%. In March, CPI rose by 5% and HICP by 6.9%. The ‘core’ sticky price CPI of the U.S., tracking goods whose prices change relatively infrequently (less food and energy), rose by 6.3% in April, a marginal easing from the peak-growth of over 6.6% in December. The core inflation (excluding energy, food, alcohol & tobacco) grew by 5.6% in April in the Eurozone, which was barely below the peak-growth of 5.7% reached in March.

The easy gains in the fight against inflation have essentially been depleted, and now the true ‘battle’ begins. The very rapid growth of core inflation implies that inflation expectation have become anchored (meaning that consumers and corporations are expecting inflation to continue rapid leading to increased wage and price pressures), which implies that rough measures are required to bring it down. We actually warned on this already in June 2021, when we argued that inflation will not be “transitory”:

If wage pressures increase, inflation expectations increase and this will translate into higher wages and prices set by corporations fuelling faster inflation, long-term. Presently there are also serious bottlenecks in supply, such as hiring difficulties, creating inflation pressures. When the prices of ‘necessities’ start to rise in the U.S., the largest economy in the world, they tend to also rise elsewhere—albeit with a lag.

I also warned in my newsletter in mid-December 2021 that if inflation is allowed to accelerate any further, heavy measures will be needed to bring it down.

What many analysts seem to fail to understand is that we are now exactly at the point, where premature rate cuts would be likely to lead to re-acceleration of inflation. The possibly even more worrying issue is that the drivers of inflation somewhat differ between the U.S. and the Eurozone, but both central banks are issuing the same ‘remedy’.

Let’s analyze the situation in the U.S. vs. the Eurozone a bit further.

The monetary shock in the U.S.

I have detailed the effects of the massive increase of the balance sheet of central banks to the amount of money in circulation in several past entries (see, e.g., this, this and this). But, how has this affected inflation?