The Federal Reserve is actively encouraging higher inflation. Last year it changed its inflation target from 2% to an average of 2%, allowing periods of overshoot to make up for the past 10 years when inflation struggled to meet the target. The bigger structural problem we face today, recognised by the Fed and the world’s major central banks, is not inflation but deflation. Japan has struggled with deflation for decades. Deflation is much harder to fix than inflation, and tends to result from an ageing population, more prone to saving than spending. An ageing population is evident throughout the western world and now also in China according to its recent census. Excessive debt is also deflationary. The world is drowning in debt, a situation worsened by the Covid pandemic, which prompted governments to resort to massive fiscal rescue remedies.

The Fed, followed by other central banks, is keenly aware that with global debt rising ever higher, it needs at all costs to avoid a deflationary trap. If it fails, the debt problem will become even greater in real terms, ultimately resulting in depression. To avoid this outcome, the Fed is purposefully staying behind the inflation curve. But will it go too far, will the increase in inflation be the saviour or will it get out of control and become a villain? The consensus opinion is that 3% is the threshold. In April, US consumer price inflation jumped from 2.6% to 4.2% year-on-year, but this had been anticipated due to the base effect of last year’s low comparative readings at the outset of Covid lockdowns. We will only know whether the inflation spike is persistent or temporary, as the Fed claims it will be, once the base effect washes out of the data, sometime next year.

Former US Treasury secretary Larry Summers warns that fiscal and monetary policy makers have “underestimated the risks, very substantially, both to financial stability as well as to conventional inflation of protracted extremely low interest rates” but Fed chair Jay Powell and the majority of economists are in disagreement. In his testimony to the Senate Banking Committee, Powell said “we might see some upward pressure on prices. Our best view is that the effect on inflation will be neither particularly large nor persistent.” The Fed’s argument is that there is significant under-utilised production capacity in businesses and in the labour market, which will keep a cap on longer-term inflation. The short-term spike will fade as supply chain bottlenecks are fixed and labour market restrictions are removed in line with an easing of Covid restrictions. Joe Biden is planning an additional $4 trillion in fiscal stimulus, but expenditure will be spread over 10 years and much will go towards infrastructure improvement, which should boost productivity and therefore be disinflationary. Meanwhile, the ageing global population, technological innovation, global trade, deregulation and the falling influence of labour unions, remain powerful disinflationary trends, and since Covid perhaps more relevant than ever.

Some argue that the rapid acceleration in economic growth resulting from the sheer scale of fiscal and monetary stimulus, the strength of household balance sheets following government helicopter drops of money, and pent-up demand, will endure beyond the initial reopening phase. The fear is less of a spike in inflation than a rise in inflation expectations. Once inflation expectations become entrenched, they are very difficult to shake off. According to the University of Michigan US consumer confidence survey in May, respondents are already expressing concerns about inflation and its effect on their purchasing power. Survey respondents regarded buying conditions for durable goods, cars and homes as the most negative since 1980. With pent-up demand so strong, companies are able to pass on higher production costs to consumers and are doing so on an opportunistic level even where cost pressures are not yet visible. US GDP could grow in 2021 by as much as 8%, the Eurozone by 6%, and the world economy by around 6%, but growth will slow in 2022 and return back to trend growth thereafter, so demand pressure should ease at the same time that supply bottlenecks are mended.

April’s US consumer price inflation figure, although a shock at the headline level, provided more sober reading upon closer analysis. The chief culprits were the sectors with demand surges resulting from the removal of Covid restrictions. On a month-on-month basis, airline fares, hotel prices and car rental prices increased by 10.2%, 7.6% and 16.2%. By contrast, medical care services were unchanged. Rents, which contribute the lion’s share of the CPI basket at 30% and an even greater 40% share of core CPI, increased just 0.2% on the month. Arguably rents will be under sustained downward pressure as the “work from home” phenomenon outlasts the pandemic and continues to encourage people to move to larger homes in cheaper suburbs and metros.

It is telling that upon the release of the April inflation data, the inflation hedges dropped in price. 10-year Treasury Inflation Protected Securities (TIPS) suffered their biggest daily decline in a month. The breakeven rate between the conventional 10-year Treasury bond and same maturity TIPS, which indicates the market’s expected average annual inflation rate over the period, dropped to 2.41%, down from 2.54% before the data was released.

The debate over the inflation threat is still wide open. We will probably only know the answer in 2022 after the once-off effects have had time to fade out of the equation. Until then, therefore, financial markets are likely to give the Fed the benefit of the doubt, even if short-term spikes are uncomfortably high. Longer-term bond yields may rise but as long as shorter-term bond yields remain anchored, which is the expected scenario given the Fed’s pledge to keep the fed fund’s rate at zero at least through 2023, global equities are likely to continue being well supported.

In South Africa, inflation is less of a worry. While we have not had to deal with the threat of deflation, inflation is also a low-risk outcome given the stresses on household balance sheets. We did not share in the luxury of massive fiscal handouts and unemployment is extremely high at over 30%. Moreover, the rand is underpinned by strong terms of trade and buoyant commodity prices, thanks to the powerful recovery in global trade. A stable rand will shield against imported inflation. Benign inflation and a stable rand, coupled with high long-term interest rates (amongst the highest long-term government bond yields in the world), should enable the Reserve Bank to maintain its accommodative low interest rate policy.