INVESTORS FEAR INFLATION IS COMING BACK. THEY MAY BE RIGHT / THE ECONOMIST

As the balloon goes up

Investors fear inflation is coming back. They may be right

Is the world in for a repeat of the 1970s?

After peaking in 2022 at 11% year on year, inflation across the rich world has steadily fallen. 

Until now. 

As central banks bring down interest rates, headline inflation across the rich world is edging up (see chart 1 ). 

It rose from 2.1% in September to 2.5% in December.

On February 19th Britain reported inflation for January: 3% year on year, up from a recent low of 1.7%. 

Polish inflation in January was 5.3%, up from 4.7% the month before. 

German inflation fell to 2.3%, but that was still above the 1.6% reached last summer. 

American consumer prices rose by 3% year on year, up from a recent low of 2.4%. 

Some wonder why central banks cut rates before inflation was at or below target, considering that economic growth has barely slowed. 

“Inflation is like cockroaches,” John Cochrane of Stanford University recently wrote. 

“When there are only a few left [it] is not the time to let up.”

Is the rich world about to repeat the mistakes of the 1970s? 

Back then, policymakers killed most of the cockroaches, but left a few of the hardiest, which then proceeded to breed ferociously. 

In America inflation hit 12% in 1974, fell to 5% in 1976 and then climbed to 15% in 1980. 

Central banks failed to adjust policy fast enough to prevent an oil-price shock in 1979 from spreading across the economy. 

Only with an enormous recession in the early 1980s, which policymakers engineered by using a shedload of borax, did they at last exterminate inflation for good.

Investors are unsure if high inflation will return. 

Market pricing points to the Federal Reserve implementing looser monetary policy in the future—and where the Fed leads, other central banks follow. 

In recent weeks government-bond yields have fallen, which might suggest worries about inflation have eased. 

On the other hand, a model from the Fed’s Cleveland branch suggests market expectations for inflation over the next year have risen from about 2.2% in September to 2.7% today.

The confusion reflects intellectual disagreement. 

Some pundits reckon that the recent rise in inflation is a mirage. 

Statisticians adjust data to reflect events that happen at a particular time of the year (such as the price rises that many shops impose in January). 

The covid-19 pandemic, which created huge volatility, has messed up these seasonal adjustments, which could make month-on-month inflation readings in January and February higher than the “true” rate of inflation. 

Others point out that headline inflation always jumps about, owing to volatile commodity prices. 

Economists at Morgan Stanley, a bank, reckon that the recent wildfires in California may have temporarily pushed up goods prices in America. 

In January a number of countries, including Belgium and Norway, saw large increases in the price of food, perhaps linked to worries over a trade war. 

Central bankers typically ignore these blips when setting monetary policy.

Yet not everyone is so relaxed. 

Whatever the problems with seasonal adjustment, they cannot affect inflation as measured on a year-on-year basis—and that is clearly rising. 

Moreover, there is evidence to suggest that the rich world is genuinely seeing more inflationary pressure. 

Alternative Macro Signals, a consultancy, runs millions of news articles through a model to construct a “news inflation pressure index”. 

The global index, which has proved to be a useful predictor of official numbers, has recently risen sharply, especially in America.

Rich-world labour markets also remain tight. 

The oecd’s unemployment rate has now been below 5% for nearly three years. 

With companies competing hard for staff, nominal wages are rising by more than 4% year on year across the biggest economies (see chart 2). 

Unfortunately, though, productivity growth is weak. 

If employers cannot spread their higher wage costs over more output, they have to pass them on to consumers in the form of higher prices.

We find evidence of this phenomenon occurring in the services sector, which covers everything from financial advice to physical therapy. 

Services prices are increasing by 4% year on year in the biggest economies, about twice the rate from before the pandemic. 

In the 18 rich countries that have reported reliable data for January, services inflation is off its recent low in 14 of them. 

In Portugal it is up by a percentage point. 

In Estonia, by 3.7 points.

Policymakers may add fuel to the inflationary fire. 

The problem is not central bankers, who should be able to resist any calls from politicians to lower interest rates. 

It is politicians themselves. 

Donald Trump plans to deport millions of undocumented workers and raise tariff barriers, which would push up prices. 

Leaders elsewhere are pursuing less extreme policies, but could still stoke inflation. 

About 40% of rich-world governments are giving their economies a fiscal boost this year, as measured by the change in the budget deficit adjusted for the economic cycle. 

Britain’s last budget increased spending on infrastructure, while Italy recently approved one containing tax cuts. 

Many governments will also retaliate against Mr Trump by imposing their own tariffs on American goods, raising the price of imports.

Compared with before the pandemic, companies and workers may react more strongly to these pro-inflation forces. 

In 2023 a paper published by the Bank for International Settlements, a club of central banks, discussed what happens in “a transition to [a] high-inflation regime”, in which rising prices become “a more focal point for workers and firms”. 

Once people have experienced rapidly rising prices, they worry about it happening again. 

If workers perceive that inflation is on the march, they may be particularly quick to ask for a pay rise.

Get pest-control in

We find worrying signs in this regard, too. 

One is interest in inflation, as measured by Google search, which is twice as high as it was pre-2021. 

Other reasons to worry come from consumer surveys. 

Even as inflation has fallen a long way from its recent peak, people still expect hefty price rises in the months to come. 

In December the eu’s inflation was below 3%. 

Yet eu citizens expect prices to rise by 10% over the next 12 months—twice as much as they expected in the 2010s. 

There is a similar “inflation perception gap” in America. 

Canada’s inflation rate has been at or below 2% since August. 

And yet Canadians still expect inflation of 3% over the next year, compared with 2.4% before the pandemic.

Not long ago central bankers were patting themselves on the back for having brought inflation down so quickly. 

It was enough of a success to have made up for the error of being too late to respond to price rises in the first place. 

As many homeowners are aware, however, cockroaches have a nasty habit of returning.