The transitory discourse on inflation is back. But economists say higher prices are here to stay

Global markets have been encouraged in recent weeks by data indicating that inflation may have peaked, but economists are warning of a return to the “transitional” inflation narrative.

Stocks rebounded when the U.S. Consumer Price Index for October came in below expectations earlier this month, as investors began betting on an easing of aggressive interest rate hikes by the Federal Reserve.

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While most economists expect a significant general decline in headline inflation rates in 2023, many doubt that this heralds a fundamental disinflationary trend.

Paul Hollingsworth, chief economist for Europe at BNP Paribas, warned investors on Monday to be wary of the return of “Team Transitory”, a reference to the school of thought that the expected rise in inflation rates at the start of the year would be fleeting.

The Fed itself was a proponent of this view, and Chairman Jerome Powell eventually issued a mea culpa accepting that the central bank had misinterpreted the situation.

“Reviving the ‘transitional’ inflation narrative may seem tempting, but core inflation is likely to remain elevated by past norms,” ​​Hollingsworth said in a research note, adding that upside risks to the headline rates next year are still present, including a potential recovery. in China.

“The sharp swings in inflation highlight one of the key features of the global regime shift that we believe is underway: greater inflation volatility,” he added.

The French bank expects a “historically significant” drop in headline inflation rates next year, with almost all regions seeing lower inflation than in 2022, reflecting a combination of base effects – the negative contribution at the annual inflation rate occurring as it changes from month to month shrink – and the dynamics between supply and demand change.

Hollingsworth noted that this could rekindle the “transitional” narrative next year, or at least a risk that investors “extrapolate inflationary trends that emerge next year as a sign that inflation is rapidly returning to the “old” normal”.

These narratives could translate into official forecasts from governments and central banks, he suggested, with the UK’s Office for Budget Responsibility (OBR) forecasting outright deflation in 2025-26 in “stark contrast to the current market RPI fixings”, and the Bank of England expects medium-term inflation to be well below target.

Skepticism about a return to normal inflation levels was echoed by Deutsche Bank. Chief Investment Officer Christian Nolting told CNBC last week that market pricing for central bank cuts in the second half of 2023 was premature.

“Looking at our models, we think yes, there is a mild recession, but from an inflation perspective, we think there are second-round effects,” Nolting said.

He pointed to the 1970s as a comparable period when the western world was rocked by an energy crisis, suggesting side effects of inflation occurred and central banks “cut too soon”.

“So from our point of view, we think inflation is going to be lower next year, but also higher than in previous years, so we will stay at higher levels, and from that point of view , I think central banks will stay put and not cut very fast,” Nolting added.

Reasons to be careful

Some significant price increases during the Covid-19 pandemic have been widely viewed as not actually “inflation”, but as the result of relative changes reflecting specific supply and demand imbalances, and BNP Paribas thinks the same is true in the opposite direction.

As such, disinflation or outright deflation in certain sectors of the economy should not be taken as indicators of a return to the old inflation regime, Hollingsworth insisted.

Moreover, he suggested that companies may be slower to adjust prices downward than to increase them, given the effect of soaring costs on margins over the past 18 months.

Although goods inflation is likely to slow, BNP Paribas views services inflation as more rigid, partly due to underlying wage pressures.

“Labour markets are historically tight and – to the extent that there has probably been a structural element to this, particularly in the UK and US (e.g. increased inactivity due to sickness UK) – we expect wage growth to remain relatively high by past standards,” said Hollingsworth.

China’s Covid politics have taken over the headlines in recent days, and stocks in Hong Kong and the mainland rebounded on Tuesday after Chinese health authorities reported a recent increase in vaccination rates among seniors, which is considered by experts as crucial for reopening the economy.

BNP Paribas predicts that a gradual easing of China’s zero-Covid policy could be inflationary for the rest of the world, as China has contributed little to global supply constraints in recent months and an easing of restrictions is “unlikely to significantly increase supply.

“On the other hand, a stronger recovery in Chinese demand is likely to exert upward pressure on global demand (for commodities in particular) and therefore, all things being equal, fuel inflationary pressures,” said Hollingsworth.

Another contributor is the acceleration and deepening of decarbonization and deglobalization trends brought about by the war in Ukraine, he added, as both are likely to increase inflationary pressures in the medium term.

The BNP argues that the change in the inflation regime is not only about where price increases take hold, but about the volatility of inflation which will be accentuated by sharp swings over the next couple of years.

“Granted, we think inflation volatility is still likely to fall from its current extremely high levels. However, we don’t expect it to return to the kinds of levels that characterized the ‘Great Moderation’. ‘” Hollingsworth said.