Vanguard Commentary: The Coming Rise(s) in Inflation

By Joseph Davis

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May 06, 2021
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A useful term, base effects, helps explain dramatic increases in GDP and other barometers of activity as economies recover from the COVID-19 pandemic. The term places such indicators in the context of a recent anomaly—in this case the dark, early stages of the pandemic that depressed global economic activity.

Base effects help mask the reality that activity hasn't yet reached pre-pandemic levels in most of the world, that labor markets are still notably lagging despite recent strength in some places, and that the threat from the disease itself remains high, especially in emerging markets. These amplified comparisons to previous weak numbers portray a U.S. economy going gangbusters. Inflation is the next indicator to be roiled in this way.

It's quite possible that base effects, as well as supply-and-demand imbalances brought about by the pandemic, could help propel the U.S. Consumer Price Index (CPI) toward 4% or higher in May and core CPI, which excludes volatile food and energy prices, toward 3%. All else being equal, we'd expect inflation to fall back toward trend levels as base effects and a shortfall in supply fade out naturally.

But inflation, once it takes hold in consumers' minds, has a particular habit of engendering more inflation. Beyond that, all else is not equal.

A real threat of persistent higher inflation

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Sources: Vanguard assessment as of April 13, 2021, using data from the U.S. Bureau of Labor Statistics, Federal Reserve Economic Data, Federal Reserve Bank of Atlanta, Federal Reserve Bank of New York, and the U.S. Congressional Budget Office.

With the tepid recovery from the 2008 global financial crisis still fresh in mind, policymakers around the world have embraced fiscal and monetary policies as aggressive and accommodative as we've seen since World War II. Base effects will no doubt dissipate, and an inflation scare that we expect to play out in coming months will likely ease. But the threat of persistent higher inflation is real.

We're watching for the extent to which any ramp-up in U.S. fiscal spending beyond the $1.9 trillion American Rescue Plan Act (ARPA), enacted in March, may influence inflation psychology. Our enhanced inflation model—the subject of forthcoming Vanguard research—investigates, among other things, the degree to which inflation expectations can drive actual inflation.

That inflation expectations could have a self-fulfilling nature shouldn't come as a surprise. As individuals and businesses expect to pay higher prices, they expect to be paid more themselves, through increased wages and price hikes on goods and services.

Fears of a self-perpetuating wage-price spiral are understandable, given the experience of older investors with runaway inflation in the 1970s. But many of the factors that have limited inflation, notably technology and globalization, remain in force. And we expect central banks that will welcome a degree of inflation after a decade of ultra-low interest rates will also remain vigilant about its potentially harmful effects.

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