Morning Commentary: The Difference Between Reflation and Inflation

A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.

The Difference Between Reflation and Inflation  Share this story: Andrew Kositkun Foreign Exchange Head Trader

One of the most common arguments for higher inflation is based on the expectation that aggressively easy monetary and fiscal policy should lead to higher prices. On the surface, this relationship seems simply enough; however, from an economist’s point of view, this oversimplifies the chain of causation between policy and inflation. More specifically, monetary easing pushes asset prices higher and eases credit conditions. Higher spending is also expected, especially when monetary policy is combined with fiscal stimulus. Sustained higher spending should put pressure on capacity to meet higher demand, and this pressure on capacity should lead to higher inflation. Empirical data shows that there has been plenty of asset price inflation; however, upward pricing pressure due to strains on capacity is less clear. Recall that in 2019, with tight capacity around the world and unemployment in the U.S. around 3.5%, the Fed, and other central banks around the world, struggled to meet their inflation targets. While labor markets around the world have made a sharp recovery, the unemployment rate in the U.S. and most of the world remains materially higher than pre-pandemic levels. A prime example of the divergence in asset prices and consumer prices can be seen with housing. Record-low mortgage rates have pushed up the demand for homes, but high unemployment has lowered people’s ability to pay rent. This results in the expectation for solid home price inflation but weak rent inflation. Note that over the long run, there is a correlation between home prices and rent, but this relationship is weak in the short and medium term. It is also unclear what will happen to prices once the COVID-19 crisis has passed. The pickup in economic activity should lead to increased demands on capacity, but the rotation in demand from goods to services should dampen this inflationary pressure. As services come back online, there should be plenty of capacity to meet increased demand. Meanwhile, the supply-constrained goods side of the economy will likely see a drop in demand as consumers return to more balanced spending. If the above analysis holds true, then inflation should remain below central bank targets for a significant period of time. Even if inflation were to move up toward central bank targets, policymakers are likely to respond very slowly, as an inflation overshoot is needed to restore faith in the idea that the inflation target is an average and not a ceiling. From a risk-asset pricing perspective, this is an important consideration, as history shows inflation-fighting central banks to be bad for risk assets. HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT: U.S. initial jobless claims disappointed estimates, as they rose to 853,000 last week versus estimates for a 725,000 print. Continuing claims increased to 5.76 million against estimates for a 5.21 million report. These numbers support the narrative of a labor market under pressure and the need for additional stimulus. Speaking of U.S. fiscal stimulus, progress continues to be difficult. As a result, the House of Representatives passed a one-week continuing resolution to keep the government funded and allow more time for stimulus talks. This resolution now sits in the Senate where it should easily pass, as the issue is not the omnibus spending bill but the pandemic relief expected to be attached to it. Headline CPI rose 1.2% year over year against expectations for a 1.1% increase. The core CPI number also beat expectations, as it rose 1.6% year over year against expectations for a 1.5% increase. While both of these readings came in higher than expected, softness in the labor markets makes inflation risks less of a concern. Brexit talks have been extended to Sunday, as last night’s dinner between U.K. Prime Minister Boris Johnson and European Commission President Ursula von der Leyen was not as successful as hoped. As expected, the British pound is down sharply. On the data front, U.K. October GDP rose 0.4% month-over-month versus expectations for a flat reading and industrial production rose 1.3% month-over-month against consensus for a 0.3% increase. Despite today’s data beats, further fiscal and monetary stimulus is likely in 2021 as the U.K. economy is still losing momentum.   The European Central Bank left its rates unchanged as expected. The bank also added 500 billion euros to its pandemic bond-buying program and extended this program by nine months to at least March 2022. Expectations were for a six-month extension. The bank’s GDP forecast for 2020 was revised to -7.3% from -8.0%, with 2021’s GDP outlook revised to 3.9% from 5.0%. The central bank also noted that it was watching the euro exchange rate very carefully. The two-day EU summit begins today, with talks focused on the long-term budget and the recovery fund. China announced that it will start collecting extra duties on Australian wines starting tomorrow. These restrictions add to existing duties on Australian timber, barley and lobsters, as tensions between the two countries continue. Thus far, iron ore, Australia’s top export to China, has avoided restrictions. With iron ore demand strong, this sector has helped offset pain felt in other areas. Mexico will look to increase the minimum wage by four times the inflation rate in 2021. According to a presentation made by Labor Minister Luisa María Alcalde, wages are set to increase from $187 a month to $215 a month in an effort to reverse inequality in Latin America’s second largest economy.

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