The Return Of Inflation

Coins, Calculator, Budget, Household Budget, Money

The return of inflation could be a major theme in markets this year. It will force the Federal Reserve and the European Central Bank to balance even more carefully its communication to avoid any taper tantrum.

It’s not quite the return of the Living Dead but the comeback of an almost forgotten relic from the past could haunt financial markets this year: inflation. In both the US and the eurozone, headline inflation is set to reach levels last seen years ago. In the US, we see headline inflation above 3% in the second and third quarters, with core inflation likely to breach 2.5%. In the eurozone, headline inflation could reach the 2% mark in the second half of the year. At first glance, these developments are linked to higher energy prices, some catch-up of price increases after the end of lockdown restrictions, and in the case of the eurozone, the reversal of the German VAT cut. The key question for markets is how sustainable all of this will be.

Inflation prospects in the US and the eurozone

In the US, inflation in the near term will be pushed higher by base effects as a weak 2Q/3Q last year is compared to (hopefully) a vibrant 2Q/3Q 2021. Remember that at the nadir of March-May 2020, businesses were shut and travel came to a standstill as people were told to stay at home. Companies were desperate for cash to pay staff and creditors and were willing to sell at deep discounts.

In contrast, we are all hoping that 2Q 2021 will be a period of economic re-awakening, with the vaccination programme having gained momentum and COVID hospitalizations plunging, thereby allowing COVID containment measures and economic restrictions to be lifted. With households and businesses free to spend, supported by high savings levels, low credit card balances and additional government cheques, we are likely to see vigorous pent-up demand.

We are hearing some monetarists suggest that the risks are skewed towards even higher numbers than our 3-3.5% forecast. These analysts are concerned that broad money supply is accelerating across this world and with the velocity of money set to pick up on an economic reopening, more vigorous inflation is inevitable. Separately, there is also concern that higher energy prices and a weaker dollar could add to US headline inflation.

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