One of the biggest economic trends worrying people right now is the rise in inflation. Over the last year, the costs of many products have gone up faster than they have in decades. But even if the inflation surge is temporary, it could raise inflation expectations, and that could have a long-term impact on the level of inflation, interest rates, economic growth, and markets.
Except for the period when gasoline prices surged in 2008, inflation is now rising faster than it has in nearly 30 years. The sudden reopening of the economy, propelled by massive government support, created enormous increases in demand, while supply chain and labor constraints limited output. This classic demand-exceeding-supply inflationary environment has provided businesses with significant pricing power.
Most likely, the current inflation acceleration will moderate over the next year. Businesses will have more time to adjust output, while the government’s payments to households and businesses will largely disappear, moderating sales. Supply and demand will become more in balance.
So why worry about inflation? Because there is another concern that is not being discussed: Inflation expectations may be starting to get out of hand.
What are inflation expectations and why do we worry about them?
Inflation expectations are what households and business believe the rate of inflation will be over time.
Expectations of how costs will increase are crucial factors in business and household decision making. If a firm thinks its costs will rise by a certain level, it will need to find ways to cover those added expenses. It will look to improve productivity, but it will also likely need to raise prices.
On the household side, inflation affects purchasing power. People can spend their income now or save it and buy goods in the future. The higher the rate of inflation, the less that can be bought in the future. As inflation rises, spending gets shifted from the future to the present.
And, finally, interest rates could be affected. The rate that financial institutions charge for loans depends in part on the need to offset inflation. Their buying power is negatively affected the same way as households’, and they need to cover that potential loss. The higher the expected rate of inflation, the higher the loan rate.
The implication is that we need to watch not just the rate of current inflation, but what is happening to expectations about what inflation may be over time.
And inflation expectations are on the rise.
There are a variety of indicators of inflation expectations, but the trends are similar in just about every method that they are measured.
For example, the Atlanta Fed’s Business Inflation Expectations Index reached a level in June that is about 50% higher than it had typically been running. The University of Michigan’s measure hit its highest level in 13 years in May.
The St. Louis Fed’s May Breakeven Inflation Rate indexes are all at their highest level in about a decade. Even the survey of Professional Forecasters (of which I am a member) indicated that inflation expectations are increasing, and it takes a lot to get economists to change their long-run forecasts.
Though not every index has inflation expectations surging, it is critical that this issue be watched carefully because the 800-pound gorilla in the economic policy room, the Fed, worries greatly about what is happening to this indicator.
The key for the Fed is that inflation expectations don’t change greatly. This was highlighted in a 2007 speech by former Fed Chair Ben Bernanke when he said this: “Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”
The Fed has two primary goals, price stability and maximum employment. Those two mandates can come into conflict. If inflation is rising too rapidly, the Fed would need to slow growth. But that could affect employment levels. If unemployment is too high, the Fed might want to increase growth, but that could lead to rising inflation.
For Fed policy to work best, inflation expectations need to be largely insulated from the ebbs and flows of the daily flow of data. If that is the case, expectations are described as being well “anchored.”
When expectations change significantly and it appears that movement could be sustained, the Fed might have to alter policy to prevent the expectations from getting too high, because businesses would start factoring inflation into their economic decisions. “Unanchored” expectations could cause inflation to accelerate, forcing up interest rates.
Related to the anchoring of expectations is the concern that the perception of the rate of long-term inflation could change. It’s been decades since businesses have had the pricing power they now enjoy. Similarly, except for the baby boomers who lived through the periods of rapid inflation in the 1970s and early 1980s, few people have given inflation much thought over the last 20 years or more.
It is possible that an extended period of higher-than-“normal” inflation could fundamentally change both business and household perceptions of what the “normal” inflation rate will be over time.
The higher inflation rates and interest rates that would result from an upward shift in inflation expectations would affect everything, from mortgage rates to equity markets.
We are not near a point where the Fed must react to the change in inflation expectations. There are frequent ups and downs in the measures. But the longer the increase continues, the greater the likelihood the Fed will have to respond, and that could mean it starts raising rates.
Indeed, an enduring gap up in inflation expectations is not inevitable. But this indicator needs to be watched carefully as a more lasting change could affect the economy and the markets significantly.
Joel L. Naroff is the president and founder of Naroff Economics, a strategic economic consulting firm in Bucks County.
The global economy is falling below expectations – The Economist
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IT IS WELL known that markets hate uncertainty. Bad news, then, that by one measure the world economy is throwing up more nasty surprises for investors. Citigroup’s global economic-surprise index (CESI), which measures the degree to which macroeconomic data announcements beat or miss forecasts compiled by Bloomberg, has fallen into negative territory for the first time since November (the indices for America and China have been negative since mid-May). Since the summer of 2020 economic indicators had tended until recently to surprise on the upside. But as inflation has surged and consumer confidence has flagged, they are now failing to meet forecasters’ expectations. (See chart.)
Measures of economic surprises appear to be a useful way to gauge market sentiment. When the economy is booming data releases will typically be better than analysts expected, boosting the CESI. During an economic downturn, economic statistics will fall below the consensus estimate, leading to negative surprises. From June 2020 to July 2021, when the CESI for America was positive thanks to upbeat employment, inflation and housing figures, the S&P 500 index of big American firms rose by 38%. Since then the CESI has bounced above and below zero, and shares have fallen by roughly 9%.
In a paper published in 2016 Chiara Scotti, an economist at the Federal Reserve, constructed her own surprise index based on five indicators: GDP, industrial production, employment, retail sales and manufacturing output. America’s index also measured personal income. Ms Scotti found that positive economic surprises in America were associated with appreciation of the dollar relative to the euro, pound sterling and yen. (In fact, Citi’s index was designed by the bank’s foreign-exchange unit for trading currencies, not stocks.)
But the surprise index can be hard to interpret. The CESI includes both backward- and forward-looking macroeconomic indicators, and is weighted in favour of newer releases and those that tend to have the biggest impact on markets. Because the index reflects economic performance relative to expectations, it can be negative during expansions if forecasters are too optimistic, and positive during contractions if they are too gloomy. But as Citi analysts wrote in a research note, “coincident rather than causal relationships are relied on even if they have no consistency whatsoever.” ■
Sri Lanka Economy Shrinks 1.6% Amid Political Chaos, Inflation – BNN
(Bloomberg) — Sri Lanka’s economy fell back into contraction last quarter as the country battled its worst economic problems since independence, with emergency aid to stabilize the island nation proving elusive.
Gross domestic product declined 1.6% in the quarter ended March from a year earlier, the Department of Census and Statistics said in a statement on Tuesday. That’s shallower than a 3.6% contraction seen by economists in a Bloomberg survey and compares with a revised 2% expansion in the previous quarter.
The contraction likely marks the beginning of a painful and long recession for the country, whose Prime Minister Ranil Wickremesinghe last week said the economy had “completely collapsed.” The crisis follows years of debt-fueled growth and populist fiscal policies, with the Covid-19 pandemic’s hit to the dollar-earning tourism industry serving as the last straw.
Absence of foreign exchange to pay for import of food to fuel led to red-hot inflation, the fastest in Asia, triggering protests against the government led by the Rajapaksa clan that eventually led to the resignation of Mahinda Rajapaksa as premier. While the months-long protests hurt business activity in parts of the country, the government on Monday imposed new curbs, which includes a call to residents to stay home until July 10 to conserve fuel.
That will depress activity further, while raising the risk of more unrest given lingering shortages of essential goods.
Sri Lanka is in talks with the International Monetary Fund for aid to tide over the crisis, with at least $6 billion needed in the coming months to prop up reserves, pay for ballooning import bills and stabilize the local currency. The central bank has raised interest rates by 800 basis points since the beginning of the year to combat price gains that touched 39%.
Other details from the GDP report include:
- For the first quarter, the services sector grew 0.7% from a year earlier
- Industrial production slipped 4.7% and agriculture output contracted 6.8%
©2022 Bloomberg L.P.
China's economy recovering but foundation not solid, premier says – Financial Post
BEIJING — China’s economy has recovered to some extent, but its foundation is not solid, state media on Tuesday quoted Premier Li Keqiang as saying.
China will strive to drive the economy back onto a normal track and bring down the jobless rate as soon as possible, Li was quoted as saying.
“Currently, the implementation of the policy package to stabilize the economy is accelerating and taking effect. The economy has recovered on the whole, but the foundation is not yet solid,” Li was quoted as saying.
“The task of stabilizing employment remains arduous.”
China’s economy showed signs of recovery in May after slumping the previous month as industrial production revived, but consumption remained weak and underlined the challenge for policymakers amid the persistent drag from strict COVID-19 curbs.
China’s nationwide survey-based jobless rate fell to 5.9% in May from 6.1% in April, still above the government’s 2022 target of below 5.5%.
In particular, the surveyed jobless rate in 31 major cities picked up to 6.9%, the highest on record. Some economists expect employment to worsen before it gets better, with a record number of graduates entering the workforce in summer.
Li vowed to achieve reasonable economic growth in the second quarter, although some private-sector economists expect the economy to shrink in the April-June quarter from a year earlier, compared with the first quarter’s 4.8% growth.
(Reporting by Kevin Yao and Beijing newsroom; Editing by Andrew Heavens, William Maclean)
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