Transcript - Bonus episode 1 - Economics in Business Asks: Is inflation going to make a comeback?

Hannah Audino:

Hello and welcome to our bonus episode of Economics in Business. I am Hannah Audino and today we’re talking all about inflation. Now after a year of low inflation in the UK, the US, and across the eurozone, economists are now turning to the question of how far and how quickly inflation might pick up again this year as economies begin to recover.

To answer that question, I am joined by Barret Kupelian, a senior economist in PwC’s economics team - hi Barret

Barret Kupelian:

Hi Hannah.

Hannah:

Before we get into this, I am going to first ask you, why should businesses care about inflation?

Barret:

Higher inflation means that the prices in the economy across the whole host of goods and services is increasing. If you are business and you are focussed on the cost side, this means that your cost base increases and that has a direct impact to your bottom line. Higher inflation also means that businesses can charge more to their clients, depending on the elasticities for the goods and services they sell. For products or services where demand is less sensitive to price changes, its an opportunity for businesses to increase prices. Finally, there is also an indirect link, which is via the financial markets. Higher inflation expectations are associated with higher real bond yields, which basically means that the cost of debt funding for governments and corporates increases.

Hannah:

Now what has sparked these discussions about higher rates of inflation this year?

Barret:

Well, the starting point of these discussions were the various stimulus packages that governments have baked into their economic plans and whether they are adequate enough. Now, the argument has been centred around the concept called the output gap. This is how far above or below your national output is from the potential GDP level, or the level of GDP which results into stable inflation.

Right now, most advanced economies around the world are operating with a negative output gap. They are operating with significant slack in their economies. Then the idea is, if your stimulus packages, and its effects through the economy fill that output gap, they you eliminate your slack and you are on your way to the recovery. If your stimulus packages are too big, then you end up with a positive output gap, which in effect means that your economy is overheating, which in turn causes inflation to accelerate. As I said before, this has implications for financial markets. If bond holders, for example, expect the economy to overheat, then this will translate to higher real bond yields, which will then tighten financial conditions and hamper the current economic recovery that is underway.

Hannah:

Now is this story focused on one country in particular, or is it a global issue?

Barret:

Right now, most of the story is concentrated in the advanced economies, and in particular in the US and the eurozone, which outside of China are the two largest economies of the world. Of course, anything that happens in these two economies has a direct implication for the UK as well. To set the context, right now the eurozone output gap appears to be roughly double that of the US. That’s not surprising as the economic hit to the eurozone from the virus has been disproportionately larger in the eurozone than in the US. In terms of policy, the monetary policy response in the US, UK, and the eurozone have been quite similar. Now where there is a discrepancy appearing is between the US fiscal response and the eurozone’s fiscal response to the pandemic.

The fiscal plans of the US and the eurozone for 2021 are quite different. Now, the US government is planning to inject almost 3 trillion dollars in the economy this year in terms of discretionary fiscal measures, whereas if you compare that to the eurozone, which is similarly sized in terms of its GDP, the eurozone’s plans, including the national plans is to inject about 420 billion euros to achieve the same objective.

Hannah:

Turning to the big question, do you think we can expect a sustained period of higher inflation this year and a subsequent increase in interest rates?

Barret:

I don’t think there is enough evidence out there to suggest that there will be a sustained period of high inflation, which then leads to interest rates going dramatically up to counter that effect. Let me guide you through my rationale, it is important to talk about the two different types of inflation that exists. The first one is the demand-pull inflation. This is the classic situation, where an economy overheats as I mentioned before, and that leads to higher inflation.

Now, I don’t think we are at that point where this could happen in a very plausible manner. If we focus on one of the largest markets that drives inflation, the labour market, before the pandemic we were in a situation where the unemployment rates were at record low levels, in the UK, US, and the eurozone, and we were not seeing high levels of inflation, because wages were not picking up. The IMF and its chief economist as well don’t think that the various stimulus packages will lead to inflation.

Hannah:

Why do you think that’s the case?

Barret:

Well, because there are some inescapable global trends like globalisation, which has made the cost of traded goods significantly cheaper; digitalisation, which has made the trading of services much easier and cheaper; as well as automation, which has been possible due to the relative decline of capital goods. Now, all of these factors put together have made the labour market much less responsive to movements in the business cycle and these are not trends that are expected to disappear overnight.

Hannah:

You mentioned there were two types of inflation, can you talk me through the supply side now?

Barret:

Yeah, the second one is much more of a cost-pull inflation, something happens in the supply side that leads to higher inflation. Central banks has had to look through these type of crises. There is some credible evidence that this might happen to in the short-to-medium term. For example, in Texas, which is responsible for half of the refining of crude oil, we’ve seen some issues due to the colder weather. In Europe we’ve seen that the price expectations for new German orders are growing fast, which signals future price increases, but some of this also has to do with what we call the bullwhip effect. Now this is much more of a distribution channel related point and it has to do with demand distortions, traveling upstream in the supply chains, from the retailers to the wholesalers, to the manufacturers. Essentially, what we are saying here is that there could be some issues with suppliers not being able to meet demand in the short run due to practical reasons.

In summary, I would say that inflation might be a bit higher than what we usually expect in the next 6 to 12 months in the US and maybe even in the eurozone, but this is due to temporary factors. The inflation expectation numbers, both from the survey of households and financial markets to date show that there is no massive movements in the expectations of future inflation.

Hannah:

Thanks Barret that’s been really useful to step through the drivers of inflation and to really analyse the outlook for this year.

Thank you for listening. For more information on our UK economic outlook, please do head to the link in the episode description. As usual, please do subscribe for future updates on our economic analysis.