By Matthias Busuttil
The evolution of the growth and inflation outlook in advanced economies has been considerably uplifted since the start of the year given the improvement in economic conditions. The number of COVID cases has come down following the Winter lockdowns but, more importantly, the ramp-up in the number of people vaccinated allowed for a safer reopening of economies. The combination of fiscal and monetary stimulus with improving business and consumer confidence constituted powerful undercurrents for a sharp economic rebound.
With that said, the high element of discretionary fiscal spending targeted to boost short-term confidence contributed to a whiplash effect in consumption as soon as containment measures were relaxed. This rapid surge in spending, combined with supply bottlenecks brought about by the pandemic disruptions, led to an outsized rise in price levels compared to the depressed levels of last year and resulted in high inflation rates.
After a decade of low inflation and, mostly, low economic growth, these elevated levels of inflation now present central bankers with the tough decision of whether to maintain the current level of monetary support at the risk of overheating the economy or scale down monetary accommodation at the risk of jeopardizing the recovery.
The sequential upgrades in the growth and inflation projections for the US and the Euro Area, as represented in the embedded chart, shows the underestimation of reflationary forces that emerged during the reopening. In both cases, there have been sharp upward revisions in 2021 projected inflation rates. In the case of the US, this was accompanied by an equally notable increase in forecasted economic growth. Whereas, in the Euro Area, the upward revision in the growth outlook was more modest but is expected to remain at a comparatively higher-level next year. The common assumption is that inflation rates are expected to drop-off next year as upward factors viewed as temporary and specific to the reopening are expected to fade.
This is why the key talking point in the upcoming monetary policy meetings of the Federal Reserve (Fed) and the European Central Bank (ECB) will be the merits and timing of a reduction in their bond buying programmes which were launched as emergency monetary injection mechanisms.
Despite the above-target rates of inflation, the Fed has shifted its focus to the state of the labour market and the recovery in employment. Payroll data has shown a solid improvement in the number of jobs month over month, with the 22 million drop in individuals employed from pre-pandemic levels narrowing to just over 5 million. At the Jackson Hole central bank symposium in August, Fed Chairman Jerome Powell has signaled the Fed’s intention to taper its USD 120 billion open-ended monthly purchase programme by year-end. Having said that, data for August shows a slowdown in the labour market recovery with a mediocre increase in job gains likely due to the surge in COVID cases limiting hiring in hospitality and leisure.
However, this will unlikely derail talks around tapering particularly since wage inflation is still high and the number of job openings is reportedly higher that the number of unemployed persons. From a monetary perspective, financial conditions are still extremely loose and continued monetary injection is viewed as increasingly less effective in addressing the economic slack at this stage. Indicators show continued economic expansion, which is why many economists are growing concerned about an inflation boom. The expectation now is that the Fed may communicate a reduction in the pace of purchases as early as September, but more likely in November.
The emphasis by Chairman Powell to delink the gradual cessation of bond-buying with policy rate increases reiterates the pronounced dovish bias with which the central bank will approach the winddown of monetary stimulus.
The ECB, on the other hand, has greater scope to maintain a higher level of intervention for longer. The long-standing dynamics that have kept inflation in the Euro Area low for so long reduces the central bank’s conviction on the persistence of the current inflationary forces - which is why inflation is expected to degrade to below the 2% target in the next couple of years. However, there is similarly less scope to maintain the current EUR 100 billion in monthly asset purchases. The strong cyclical rebound in Europe has likely accelerated in the third quarter when most nations have almost fully withdrawn restrictions on mobility. Labour market developments have been positive showing little scarring effects. Given this solid trajectory the ECB is expected to reduce the monthly pace of purchases given that emergency conditions have, by and large, subsided.
In any case, the ECB is still expected to maintain a high degree of monetary accommodation for the foreseeable future. A reduction in the pace of ECB purchases is deemed to be less meaningful in economic terms given that it has communicated the total target amount of purchases of EUR 1.85 trillion under the Pandemic Emergency Purchase Programme, which currently makes up EUR 80 billion of monthly purchases. The remaining EUR 20 billion in monthly asset purchases under their open-ended programme will unlikely be lowered for the time being.
Whilst we will remain in the realms of very loose monetary policy, improving conditions justify a rethink of central bank measures and their role during the recovery. Despite the broad expectations of a normalising policy cycle in advanced economies, the lingering COVID related uncertainty around these forecasts set a high hurdle for any preemptive action.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.