The hypothesis of a second inflation peak

While core inflation in the euro zone had fallen to +5.3% in May, it is now holding at +5.5%. In the United States, inflation ” hard “ rose to +4.7% over one year, while headline inflation rose again to +3.2%. In addition, the IMF anticipates global inflation in 2024 of +5.2%, which remains well above pre-2020 levels, around +3.5%. Under these conditions, we cannot yet speak of the disappearance of inflation, and some economists are wondering about the potential return of inflationary surges.

Inflation struggles to come down to its target

Peak inflation is behind us. Maximum inflation was reached in July 2022 in the United States at +9.1%. In the euro zone, peak inflation was recorded in November 2022 at more than +10.5% year on year. Since then, the inflation rate has fallen to +3.2% in the United States and +5.5% in the euro zone. Consequently, the rate of inflation remains abnormally high. The authorities are mainly counting on a gradual normalization of inflation by 2027. But nothing has been won yet, and structural tensions remain high in many regions.

Thus, in the euro zone, inflation on leisure, education, health and catering continues to rise. The wage growth rate also remains close to 5% over one year. It is interesting to note that core inflation, ie inflation excluding commodities and energy, is holding at around +5.5%. In practice, if headline inflation falls below core inflation, it is likely that headline inflation will rise again to reach its structural level. Indeed, if wages increase by 5%, but the cost of living increases by 3%, it is likely that aggregate demand will increase, and eventually the price and inflation. In the euro zone, the decrease in inflation is therefore confronted with the level of the rise in prices in services, wages, etc.

For the euro zone, it is therefore difficult to imagine a rapid fall in inflation below 5%. Only a recession, or a sharp drop in commodity prices, could cause a trend reversal. In the case of the United States, headline inflation presents a greater gap with underlying inflation.

IMF projections

The IMF published its new inflation projections in July 2023. The institution raises its inflation expectations and recalls that inflation should remain more persistent. Indeed, it is stated that “about half of the economies are not expected to experience a decline in core inflation in 2023”. The overall inflationary situation therefore remains poorly oriented, and very far from the objectives set by the central banks.

“She turns out more persistent than expected, mainly for advanced economiesfor which the forecast has been revised upward by 0.3 percentage point for 2023 and 0.4 percentage point for 2024 relative to the April 2023 WEO. […] On an average annual basis, around half of the economies are not expected to experience a decline in core inflation in 2023, although on a fourth quarter basis, around 88% of the economies for which quarterly data are available are expected to see a decline. Overall, inflation is expected to remain above target in 2023 in 96% of economies with inflation targets and in 89% of those economies in 2024.”

Source : World Economic Outlook Update, July 2023: Near-Term Resilience, Persistent Challenges (imf.org)

The low level of unemployment also implies tensions on the labor market. The unemployment rate in the United States is 3.6%, against 6.5% for the euro zone. These are historically low levels. Similarly, the indexation of certain salaries to inflation could encourage this spiral of sustained demand. On the aspect of employment, the ground is therefore conducive to the persistence of inflation.

The rise of certain raw materials

We asked Alexander Lohmann, an economist specializing in Brazil and inflation, about his position on the coming price catalysts. Inflation in Brazil rose from less than 3.2% in June to almost 4% in July.

“The rise in the price of oil – driven by the drop in inventories in the US and the voluntary production cut in Saudi Arabia – was aggravated by the surge in the RBOB-Brent and Diesel-Brent cracking spreads, strongly impacting prices at the pump. At the same time, pessimistic forecasts for El Niño (+1.7 degrees at the start of 2024, signal of a strong El Niño) should push global food price inflation from the fourth quarter. These two supply shocks will collide with the deceleration in core inflation. »

Alexandre Lohmann for Tremplin.io, economist specializing in Brazil and inflation – August 21, 2023

Indeed, over one month, the price of oil (WTI) rose by more than 7%. The price of a barrel had however fallen back to its 2021 levels. Added to this are the climatic effects. Similarly, the price of wheat has returned to its levels of 2 years ago, but the fall in the price currently seems to be easing. As far as metals are concerned, the price of copper remains at high levels, while the price of steel increases slightly, as does cotton, etc. Similarly, the price of sugar remains very high and continues to increase by nearly 20% since January 1.

All of these indicators show that the downward trend in commodity prices, which has accompanied disinflation so far, is now reversing. If the evolution of raw materials is not yet likely to generate inflation, the recent evolution nevertheless calls for caution.

The other effect weighing on inflation is that of currencies. Indeed, the slight fall in the dollar in recent months has slowed the decline in inflation, the price of imported goods and services being higher. In the euro zone, imported inflation could remain very high if the ECB does not increase its key rate sufficiently.

The hypothesis of a second shortage shock

We have shown that the hardest part in terms of reducing inflation remains to be done. The economy is still geared towards a logic of growth, sustained demand and low unemployment. But at the same time, the shock of shortages observed in 2021 and 2022 has subsided. However, the authorities retain the still heavy risks of unexpected shocks on inflation. The war in Ukraine maintains uncertainties on Russian oil production, on cereal production in Eastern Europe, and more generally on the risks of international conflicts.

“The war in Ukraine could escalate, causing food, fuel and fertilizer prices to rise further. The recent suspension of the Black Sea Grains Initiative is a cause for concern in this regard. Such adverse supply disruptions could affect countries asymmetrically, implying different dynamics for core inflation and inflation expectations, divergent policy responses and further currency movements. »

World Economic Outlook Update, July 2023: Near-Term Resilience, Persistent Challenges (imf.org)

Back to the 1970s?

Moreover, the lesson of history also deserves special attention. If the economy does indeed move in long-term cycles (roughly 5-6 decades), we regularly see inflation spike around the top of that cycle. The graph below compares the evolution of inflation in the 1960s and 1970s and the evolution of current inflation. There is a clear symmetry between the two curves, all the more valid as it is separated by a duration close to 47 years to 50 years. Of course, the inflation rates over the two periods are different by a few points.

As part of this analysis, we were to see a decline in inflation between mid-2022 and early 2024 for the United States. Then, we could see a stagnant plateau near 3% to 4%, before a further upturn in inflation, possibly after 2026 under the assumption of symmetry. Of course, if the long cycle affects economic conditions, the context in which inflation spreads is different from one period to another. It is therefore not possible to base inflation expectations on this approach, but it nevertheless constitutes a warning.

At the same time, the growing risk of recession contradicts the idea of ​​an increase in inflation from 2025 or 2026. Otherwise, we could be dealing with a stagflation-type recession (high inflation and recession). This would only be possible if companies were no longer able to produce, forced to lay off or reduce their investments, and could not meet demand. What is moreover characteristic of an inflation of shortage.

In conclusion

Clearly, we have shown that inflation is struggling to come down sufficiently. Inflation ” hard “ remains close to 5% in the main economies. Moreover, the reduction in inflation seems to be drying up. Added to this is the low level of unemployment, sustained economic demand, and rising wages. Thus the IMF has raised inflation expectations, and the path to reducing the rise in prices could be more difficult. The institution states that “ half of the economies are not expected to experience a decline in core inflation in 2023“. Consequently, the level of inflation should remain well above the target set by the central banks for a long time to come.

The observed fall in inflation has so far been accompanied by a fall in inflation on raw materials and energy. But this reduction is diminishing, and in some cases we are witnessing a rebound in commodity prices. Inflation in the 1970s is fairly symmetrical to current inflation, including in the timing of trend reversals. Finally, the persistent context of war, and any other political, climatic, financial or other shock, could also generate significant and brutal inflationary risks.