How long will it take for inflation to hit 2%? Hint: much longer than you think

An inflationary regime change is underway

As we have argued in a previous article, we believe that inflation is in a structural shift and that the decades of low inflation are coming to an end. The world is moving into a new regime where structural forces will lead to a more persistent rise in inflation in the years ahead.

The decade ahead will likely be characterised by shortages in commodity and labour markets.

Fossil fuels are not going away anytime soon. While the world has been shifting towards renewable energy sources, the increase in renewable energy has not been keeping pace with rising energy demand. Furthermore, renewables are at the mercy of the weather. All these means that fossil fuels are here to stay. However, with the structural under-investment in upstream oil and gas assets likely to persist, this is setting the world up for an even tighter energy market in the years ahead.

The green transition will also contribute to longer-term inflation, as it is likely to create a huge boom in demand for metals that are vital for the technologies underpinning everything from electric cars to renewables. However, the current supplies of these critical metals are inadequate to satisfy future needs. Don’t count on supply to ramp up quickly in the short term: building mines can take anywhere between five and 25 years, while investments in mines have also been depressed by environmental, social and governance (ESG) concerns.

With farmers increasingly confronted with rising instances of extreme weather patterns, the impact of climate change will also continue to challenge agricultural yields, making it a long-term driver of food price inflation. Meanwhile, rising food protectionism across the world will add to the vulnerabilities of the global food supply, subjecting it to more price shocks in the years ahead.

Shortages are now arguably the most acute in the labour market, where extremely high job vacancies underpin hefty wage increases. The global labour shortage could be exacerbated by demographic changes, including an ageing population and a broader decline in immigration. As companies’ labour costs rise, they will likely pass them on to consumers in the form of higher prices.

Moreover, the powerful disinflationary force of globalisation is now in retreat. With geopolitical tensions now on the rise, protectionism and trade conflicts will likely be a regular occurrence. As countries increasingly focus on self-sufficiency, the trend of “reshoring” or “friendshoring” will likely accelerate, reducing efficiency and international access to cheap labour, both of which will drive up inflation in the long run.

Beyond these structural drivers, there are also other reasons to believe that inflation may remain higher for longer. We outline these reasons below.

(Related article: Low inflation is gone for good. Here’s how to position for a new era of higher inflation.)

Loose fiscal policies make it harder to achieve 2% inflation target

Even as central banks across the world have tightened their monetary policies over the past year in a concerted effort to curb inflation, governments have moved in the opposite direction by implementing loose fiscal policies, spending lavishly on everything from tax cuts to subsidised energy bills. As these measures are likely to stimulate the economy and further boost inflation, loose fiscal policies make it even harder for central bankers to fight inflation.

Start with the economic stimulus during the pandemic.

Over the course of 2020 and 2021, governments spent an estimated 10% of global GDP supporting their economies. Formally, this stimulus ended some time ago, but in reality, it is still working its way through the system. Of the USD 4.5 trillion in total Covid-19 aid spending announced by the US, only USD 4 trillion in actual payments have been made to date (as of 30 September 2022), meaning that there are still about USD 500 billion or so in available relief resources that have yet to hit the economy. Europe has also yet to splash out EUR 225 billion in unused loans from its Covid-19 recovery funds.

On top of Covid-19 stimulus packages, governments have also been spending freely to help households and firms cope with soaring energy and food prices. While the US has passed the Inflation Reduction Act, a climate-change law that will also include hundreds of billions in deficit reduction, President Joe Biden’s proposed cancellation of student debt is expected to cost roughly twice as much as the act will save.

Europe, which is adapting to life without Russian gas, has also been spending to shield its economy from rising energy bills. According to Bruegel, European governments have pledged more than EUR 710 billion in stimulus measures, including support for utilities. France is capping energy prices and has fully nationalised EDF, an energy giant. Even the typically frugal Germany has cast aside its long-held fiscal austerity, shelling out EUR 200 billion on an “economic shield” to protect households and businesses from skyrocketing power costs.

Governments are unlikely to tighten their purse strings anytime soon. Ageing populations will push up future outlays on healthcare and pensions. Spending on climate change technology and clean energy will also accelerate as governments pursue their net-zero objectives. After Russia’s war on Ukraine, NATO members, including Italy and the Netherlands are reiterating previously unmet promises to meet their target of spending 2% of GDP on defence. Even the once pacifist-leaning Germany and Japan are massively increasing their military spending.

Such loose fiscal policies are likely to make it even harder for central banks to achieve their 2% inflation target. As we’ve seen in the case of the UK, the Bank of England (BOE) has warned that it will have to push interest rates even higher after the mini-budget was announced by the now-defunct Truss government. To bring inflation down, both monetary and fiscal policies have to work together. While much credit has been given to Paul Volcker for his role in ending the 1980s inflation, it was only after President Ronald Reagan established fiscal tightening that inflation finally settled at low levels.

Even a global recession will not vanquish inflation. 

Such is the stubbornness of price pressures, that even a global recession may not be able to tame inflation. While the drag on economic activity from the globally synchronised tightening will intensify in the quarters ahead, a global recession – if one arrives – is likely to be mild, as households in rich countries are still sitting on trillions of dollars of excess savings (relative to the pre-pandemic norm) that will allow them to keep spending even as inflation has eroded their incomes.

As the global economy heads for a recession, some increase in unemployment seems inevitable, but shortages in labour markets are so acute that the demand for labour has a long way to fall before it matches supply. In the US, there are now almost two vacancies for every person currently registered as unemployed (Chart 1). Wages in October were 5.2% higher than a year ago, well above the 3.5% that would be consistent with the Fed's 2% inflation target. In Europe, the labour market also remains exceptionally tight. Wage growth has been accelerating, with the situation made worse by the increasing risk of strikes, as workers push for higher pay.

Chart 1: Demand for labour in the US remains high

Worryingly, inflation expectations are ticking up. According to the New York Fed’s monthly Survey of Consumer Expectations, consumers in the US expect prices to rise by 5.9% for the year ahead, the highest level since July (Chart 2). The inflation expectations of the US firms that actually set prices are just as concerning. A survey by the Cleveland Fed revealed that US firms are currently expecting inflation of 7% over the next year, the highest level since the survey began in 2018.

Chart 2: Inflation expectations are ticking up

Even as recent inflation data has come in lower-than-expected, one month does not make a trend. Take a step back, and there is scant evidence that inflation is primed for a quick reversal. In fact, price pressures have been broadening. The Cleveland Fed’s trimmed-mean inflation, which excludes the biggest outliers in either direction from the consumer price index’s components and takes the average of the rest, stood at 7% in October (Chart 3). Meanwhile, the Atlanta Fed’s sticky inflation measure, which looks only at the goods and services whose prices are hardest to change, was at 6.5%.

Chart 3: Price pressures have been broadening out

All of this means that a recession would not be sufficient in itself to bring down inflation and that we are still some way off in achieving the Fed’s 2% inflation target. Given that there are also lags between tighter monetary policy and inflation, it is not a straightforward task to bring inflation down in a short period. Central banks could attempt to tame inflation by hiking aggressively, but it is unclear if they are willing to risk a deep and painful recession to achieve that. 

Moreover, overly-aggressive rate hikes could have unintended consequences on the global financial system that has long been accustomed to a low-interest rate environment. Earlier in September, a sharp spike in yields in the UK triggered a rout in the gilt market, long thought to be amongst the safest parts of the financial markets, and a pension fund crisis that the BOE had to intervene. Financial upheaval often happens in unexpected places. It is unlikely that central banks would want to risk causing serious disruptions in financial markets with aggressive rate hikes.

We believe central banks will most likely opt for a gradual approach in their fight against inflation, giving the economy a chance to slowly adjust to tighter financial conditions. The cost of this approach, however, is that central banks will have to live with higher inflation, and that interest rates will remain higher for longer. Don’t expect a Fed rate cut anytime soon, even if a recession hits.

How long will inflation take to come down? Much longer than you think

How long will it take for inflation to hit 2%? In case anyone thought that inflation would be easy to control, here is a piece of good news: 2% inflation is achievable.

And now for the bad news: based on historical data, inflation across advanced economies has taken an average of 10 years to return to 2% once it breaks above 5%, according to Bank of America (Chart 4). In a similar study conducted by VanEck, inflation took a whopping 18 years to moderate to 2% once it breaches 5%. Either way, inflation has taken an awfully long time to come down.

Chart 4: Inflation has taken an average of 10 years to return to 2% once it breaks above 5%

In another sign that the inflation beast is likely harder to tame than investors had assumed, the central banks that have tightened much earlier and more aggressively than the Fed, including Brazil, Chile, and South Korea, are still facing persistent inflation.

Brazil, which started its tightening cycle in March 2021, was one of the most aggressive central banks, raising its interest rates from a record-low of 2% to 13.75%. Its inflation, however, remained stubbornly high at 6.47% in October, well above the central bank’s targets of 3.25% for next year and 3% for 2024.

Chile’s central bank has also tightened aggressively since July 2021, taking its interest rate from 0.5% to 11.25%. Furthermore, its government has also made an effort to tighten fiscal policy. While implementing austerity during a cost-of-living crisis would be deeply unpopular, Chile has nonetheless taken the plunge and is expected to deliver a budget surplus this year. Despite their best efforts, Chile’s annual inflation rate, at 12.8%, is still more than four times above the central bank’s 3% target.

All over the world, inflation has proven extraordinarily difficult to bring down.

Stagflation nightmare ahead?

Buckle up, inflation will take much longer than you think to moderate. Consequently, with the Fed unlikely to cut rates anytime soon, interest rates will also be higher for longer. Coupled with an impending global recession, the world could be headed for a stagflationary environment characterised by slow growth and persistently high inflation.

How should investors navigate this environment?

At the asset class level, we now have a preference for fixed income over equities, as we are starting to see attractive value emerging within this asset class. While the focus this year has been on the sharp decline in global equity markets, fixed income markets have also suffered a brutal sell-off this year, with global bond yields climbing to levels that were last seen during the global financial crisis. On top of that, the valuations of bonds have turned much more attractive as compared to equities.

With fixed income, our preference is for short-duration bonds as short-term bond yields have moved significantly higher as compared to long-term yields, implying that investors can receive alluring yields without having to take on greater duration risk. Given our view that markets are underestimating the persistence of inflation, we see the potential for long-term yields to move up further. An unconstrained bond strategy is also viable as it allows for better management of interest rate risk in this tough environment.

(Related article: 3 recommended funds that can give you higher rates than fixed deposits)

Within equities, we prefer the US and Japan. Furthermore, given our expectations that inflation is likely going to be higher for longer, value stocks and commodity-linked equities will be amongst the winners. Investors could also consider ASEAN equities for their supplementary portfolios, as the region is poised to benefit from the shift of production away from China.

(Related article: ASEAN: Resilience in a sea of uncertainty)

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Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.