Scope Ratings Sees Inflation Moderating by 2022 but to Somewhat Higher Trend Rates Versus Pre-Crisis

Current high levels of inflation largely reflect transitory factors as associated with surges in commodity prices and the release of pent-up demand as economies have re-opened. Demand is being further amplified as stimulus and economic support policies continue, accentuating pandemic-associated supply-demand mismatches. Monthly YoY US CPI was 5.4%, 2.5% in the UK, and 1.9% in the euro area according to latest June data.

In this respect, we foresee elevated inflation easing by 2022 as economic conditions normalise. But only after inflation jumps higher in specific markets, such as in the UK or the euro area, in the second half of 2021.

In the long run, multiple factors hinder sustained elevated rates of inflation

With regard to long-term consumer price inflation, there remain multiple critical factors that hinder sustained elevated price increases, such as the forces of globalisation, technological innovation, automation, even social dynamics such as the disinflationary effects of ageing populations and rising inequality.

Normalisation of consumer-price inflation expected, but to somewhat higher trend rates

Nonetheless, there is a distinct possibility that consumer-price inflation will normalise from current highs but settle at somewhat more elevated trend rates post-crisis versus pre-crisis. This in part reflects the effects of structurally looser monetary and fiscal policies after this crisis.

All else being equal, changes in policy making orthodoxy over this past decade mean the policy reaction function may favour comparatively more accommodative global monetary policy setting and higher rates of public investment and consumption post-Covid compared with policy norms after the global financial crisis.

This includes more dovish G4 central banking exemplified via the outcome of the ECB’s strategic review. Dovish policy has been exemplified in the secular decline of rates to the lower bound, the introduction of negative rates, the fact that central-bank balance-sheet expansion has now become conventional, and recent transitions to symmetrical inflation objectives tolerating higher rates of inflation. These policy accommodations could anchor favourable private investment conditions, growth in commodity prices, and slightly higher market-based inflation expectations and wage & pensions growth. In addition, lower-for-longer policies pressure higher rent costs as housing prices continue hitting records.

Freer-spending post-crisis budget conventions are also seen presenting more durable inflation outcomes, at least as compared with the disinflationary austerity, internal devaluation and deleveraging orientation after the 2008-09 crisis.

Inflation rates averaged 1.8% in the United States over the 2010-19 decade, 2.2% in the UK but only 1.4% in the euro area and 0.5% in Japan, with these averages possibly seeing upside over the 2021-30 decade as inflation objectives are similarly revised up.

The sovereign ratings impact of prevailing inflation risk includes positive and negative components

The sovereign ratings impact of prevailing inflation risk includes both positive and negative components. On one hand, somewhat higher trend-rate inflation leads to higher nominal growth, supporting the trajectory of debt-to-GDP ratios provided there is not an outsized response in government bond markets to higher rates of inflation. This is credit positive.

On the other hand, increases in government bond yields and in corresponding weighted average costs of the public debt portfolio might exceed the increase in inflation should inflation prove more durable, with markets demanding higher real yields to offset greater uncertainty surrounding the outlook for price rises and with central banks more limited in capacities to intervene in markets should inflation persistently be testing a 2% objective. This could hold more adverse implications for sovereign credit outlooks.

More pronounced or persistent inflation remains a central risk to the economic outlook

In the end, as highlighted in our June 2021 Sovereign Outlook, a sharper spike in or a more prolonged bout of inflation than currently anticipated remains a prime risk to the economic outlook. The Agency’s stressed economic scenario sees inflation risks triggering a “taper tantrum” and a rush to safe-haven assets. Here, given the effects of easy money policies in inflating global asset prices much more than they have driven consumer prices higher, any lagged adjustment of monetary policies and sudden tightening of global financial conditions could put financial stability and recoveries at risk.

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Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH. Dennis Shen, Director at Scope Ratings, contributed to writing this commentary.