Inflation is back. US CPI inflation hit 5.0% this May, the highest reading in 13 years, while UK inflation soared above the Bank of England’s target to 2.1% in the same month. Even the eurozone, where a slower initial vaccine roll-out has led to a delayed recovery, saw above target inflation of 2.0% last month. Huge fiscal stimulus packages, supply chain disruptions and expectations of booming demand have ignited fears of sustained, high inflation, and people are beginning to question whether the central banks will act.

These readings have caused concern among many that a return to the hyperinflation of the 1970s is potentially on the cards, especially as mass government spending and extremely loose monetary policy have been attributed as key drivers for the price hikes in the 70s. One important point of divergence between the current picture and that of the 1970s, however, is that employees today are much less likely to be in a union which means organised labour does not have the same bargaining power as it did back in the 70s.

Until now, central banks have quickly dismissed any concerns about high levels of inflation, citing that the changes in price levels are transient. High levels of savings combined with pent-up consumer demand has released a wave of consumer activity across those countries able to ease lockdown restrictions. This rise in demand has been met with rising prices, as businesses look to reclaim lost revenues from the previous year. This effect has been exacerbated by pandemic-induced supply chain bottle necks, leading to higher prices for producers. And ultimately, inflation for many categories is still distorted by the comparison against the months when the impact of the pandemic was felt most acutely in Q2 2020.

These explanations have provided justification for central banks to consider the price spikes as purely transitory. Despite the ongoing overall dovish judgement of the current inflationary spike, members of the Federal Open Market Committee seem to be changing their minds about when interest rate rises will be required.  A majority of members now believe that two interest rate rises will be seen during 2023, and seven of the eighteen members now expect to see interest rate rises sometime during 2022.

The real (and most difficult) question, is when will central banks stop considering inflation as transient? In Cebr’s view, the danger will come if wages start to increase and in turn feed into higher inflation. Some wage inflation is already occurring on the back of a supply-demand mismatch in the labour market, resulting from labour shortages after the pandemic. Both in the US and the UK, reports have made the round on the labour shortage in sectors such as hospitality.[1] This will be compounded by a drop in the number of older workers, many of which have retired early amid the pandemic. With fewer workers available, businesses must offer higher wages, handing their employees more spending power. This in turn could further stoke inflationary pressures. The important thing to consider here is that the labour shortages are still confined to a few sectors, rather than an economy-wide problem. This, along with lower unionisation rates, will likely work to weaken the link between wage rises and inflation.

We should not, however, dismiss the possibility that the economy has changed in a more structural way. The widespread adoption of remote working practices in certain industries removes an important constraint on employees, namely that they can only apply for jobs in a commutable distance to their home (or else, have to undergo the cost and hassle of a house move). This opens up a host of new opportunities for such employees, suggesting that bargaining power between workers and businesses could indeed have shifted on a broader scale. Given these changes in the economy, central bankers should be careful to declare the wage-inflation spiral non-existent.

[1] https://cebr.com/reports/the-boot-on-the-other-foot/

For more information please contact:

Oliver Gatland ogatland@cebr.com phone: +44 (0)20 7324 2850