Richard Coghlan and Chris Faulkner-MacDonagh are portfolio managers in the global multi-asset division at T. Rowe Price in Tokyo and Baltimore.
Inflation concerns have sparked a great debate in markets, especially with the recent news that prices in the core personal consumption expenditure index-the Federal Reserve's preferred inflation measure stripping out volatile food and energy prices-rose a larger-than-expected 3.1% in April over the same period in 2020.
Still, the prevailing view is that this current bout of inflation is entirely transitory, owing to weak inflation prior to COVID-19, a temporary bump in energy prices and the temporary dislocation resulting from so many sectors opening up simultaneously. This view is understandable. Historically in the aftermath of recessions, particularly one as deep as the one caused by COVID, inflation remains subdued.
It is worth remembering, however, that this was not a classic, end-of-cycle recession. Rather, the market is very likely missing the coming magnitude of the cyclical upswing in prices and is unprepared for -- and has not yet priced in -- a cyclical inflation shock. Unexpected inflation is a risk for many investors who might have underinvested in real assets and other inflation-sensitive assets.
The first reason for concern is that starting conditions for inflation are quite strong, especially against the backdrop of tight supply conditions. Instead of sharp falls as in other recessions, U.S. headline inflation fell only modestly in 2020, and broad measures of price pressures actually rose in the year. Indeed, since the fourth quarter of 2020, commodity prices have surged 30% or more. As a result, sequential inflation may now rise significantly.
The shift to online shopping, working from home and other social changes during COVID-19 have also put companies out of business, reducing overall capacity. At the same time, there is an unusual cyclical shortage of inventories across many sectors of the U.S. economy, which we are seeing play out in daily news headlines as companies try to fill customers' orders.
As demand recovers, the associated restocking could boost U.S. economic growth by up to 6% per quarter over several quarters, likely returning GDP to its precrisis trend level faster than many expect and closing the economic shortfall due to COVID-19.
The second reason for concern reflects a rapid recovery in U.S. labor markets, which are tightening at a historically rapid pace. As the economy continues to recover, companies are struggling to fill positions, and by any standard, the current unemployment rate of 6.1% is low.
Typically, it takes two to four years after a recession ends to reach the current levels of unemployment; however, in 2020, it only took eight months. While the strong recovery helps to explain tight labor markets, these trends are also occurring against the backdrop of an aging population and the slowest growth in the working-age population in 70 years.
There is also likely to be less downward pressure on wages from high unemployment as compared with the 2000s and 2010s. During that period, many blue-collar workers were forced to take lower-paying service sector jobs, competing with workers already in those industries and driving down wages.
After the coronavirus shock, by contrast, manufacturing employment quickly recovered to over 95% of its precrisis level. There is thus a smaller pool of remaining unemployed blue-collar workers to work in the service sector, leading companies to scramble to hire workers.
Third, the commodity sector has also seen weak investment in recent years, suggesting supply conditions in these important upstream industries could tighten further in 2021 as demand increases. In mining, for example, there are few signs that the recent run-up in iron ore prices is prompting a capital expenditure response.
Similarly, current oil consumption remains at about 2 million barrels per day above production, but oil drillers are bringing rigs back online only slowly. Commodity prices have thus unsurprisingly surged, with higher raw material input costs likely to feed into inflationary pressures in the coming months.
Fourth, global capacity is also tighter than in the mid-2000s, in part due to repeated rounds of Chinese supply cuts that are leaving Chinese producers with less spare factory capacity. In addition, an increasing amount of incremental investment in China today is going to service depreciation rather than new greenfield productive capacity. As a result, China may become less of a source of global deflation pressures than in the past.
Finally, low-income and middle-class Americans are more likely to increase spending with the signing of the recent American Rescue Plan Act, which will erode labor market slack ever more quickly. Meanwhile, Chinese demand, especially for infrastructure and housing, and growth are also expected to remain resilient in 2021, further reducing the risk of deflation pressure.
Such conditions convince us that inflation will accelerate in 2021. Still, there are compelling arguments against our outlook.
Coronavirus could well come back to weigh on economic activity, particularly in light of new variants and their impact on the efficacy of vaccines. Another factor is that as significant structural forces explain the current low inflationary environment, it is true that globalization, productivity enhancements and technology will not disappear anytime soon.
China's aim to tighten credit conditions also threatens to dampen global inflation, as the authorities seem to be prioritizing their deleveraging campaign and showing an increased willingness to allow defaults -- even if both come at the cost of a more muted recovery. Finally, there is every chance inflation may be tempered if the dollar appreciates on the back of a roaring economy.