BlackRock Investment Institute

Macro insights

An inflation tug of war

The coronavirus pandemic has spurred both a steep decline in demand and huge pressures on supply. This unusual combination has implications for the path of inflation: the former pulls inflation down, but the latter pulls it up. Our view? In the short run, weak demand is likely to win this tug of war, helped along the way by the fall in oil prices. Yet inflationary pressure could build up more quickly than expected due to curtailed capacity in personal services, profound shifts in monetary policy and secular trends such as deglobalization.

BlackRock U.S. CPI Inflation GPS and breakdown, 2004-2020

Sources: BlackRock Investment Institute, with data from Haver Analytics, June 2020. Notes: The inflation GPS shows where core (excluding food and energy) consumer price inflation (CPI) may stand in six months' time. The chart shows the breakdown of the GPS components. Individual contributions are shown as deviations from their sample means. Unemployment is the headline unemployment rate. Shelter is a consumer price measure of rent costs. Trend is the underlying, slowly evolving inflation trend. Miscellaneous is the average impact of effects not controlled by our model. Forward-looking estimates may not come to pass.

Our Inflation GPS illustrates the disinflationary potential of the coronavirus pandemic in the short term, with both the U.S. (see the chart above) and euro area indicators falling sharply. The sudden increase in labor market slack – as workers have become unemployed or been moved to short-time work programs – has been a driver. For the U.S., we find that the sharp rise in the unemployment rate has been the most important factor, while in the euro area it has been broader underemployment given the prevalence of short-time work programs.

We can also get a sense of the short-term inflation impact of the coronavirus shock by looking at the parts of the Consumer Price Index (CPI) basket most exposed to social distancing. Restaurants, hotels, hairdressers, package holidays, transport, recreation and education make up around 15-25% of the CPI baskets across the U.S. and Europe. In the wake of the reopening, a material decrease in capacity due to more rigorous health and safety standards will likely cause upward price pressure in the near-term.

Inflation expectations are also a key driver of inflation. Medium- to long-term expectations have fallen for both professional forecasters and market participants. Yet the plunge in oil prices muddies the water. Inflation rates implied by breakeven rates (the difference between the yield of a nominal bond and an inflation-linked bond) have started to retrace part of their initial fall in the U.S. and have stabilized in the euro area.

Inflation expectations may drift higher once the ongoing policy revolution becomes more fully appreciated. Monetary policy could become another source of longer-term price pressure as central banks may prioritize financial stability – notably debt sustainability – over price stability. Major central banks were already showing more tolerance for inflation by moving toward average inflation targeting. Real money growth in the U.S. has shot up to 20% year-on-year. Such a surge in money supply growth might also influence inflation expectations, even though the relationship has loosened since the 1980s.

In recent decades, the persistent decline in inflation coincided with a consistent increase in globalization. This process could now unwind, as the need for onshoring important supply chains rises in the wake of the coronavirus shock and due to geopolitical and trade disputes. As globalization retreats, market concentration is on the rise. This means large companies will have more pricing power than in the past and could more easily pass higher labor costs on to consumers.

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