Bursar’s Review Summer 2021 Sample

Summer 2021 www.theisba.org.uk 12 Finance Rising costs for all those clicks? Shipping costs are also causing some consternation, but we can’t see them moving the dial on core inflation that much either. They haven’t in the past. Our analysis shows the correlation of annual shipping costs with goods inflation is statistically non-existent. Shipping costs are typically volatile, regularly rising or falling by over 50 percent in a year. Capacity is fixed in the short-term and moving ships from one route to another isn’t straightforward. During the rapid phases of economic recoveries, it’s normal for shipping costs to rise sharply. That said, it’s important to remember that global trade has already risen above pre-COVID levels and cost pressures should ease as consumers start to spend more on services relative to goods as lockdowns ease – services are less impacted by shipping costs. All told, shipping is unlikely to add more than a few tenths to inflation over the next few months. The surge in the input cost sub- indices of various purchasing managers’ surveys has excited inflation hawks. They have risen to a level not seen since 2008. But today’s elevated levels were normal in the 2000s, when inflation did not get out of hand. Moreover, while these indices are a very good leading indicator of inflation, today’s levels are only consistent with a core PCE inflation rate just over 2.5 percent, which is a level that would be welcomed by the Fed, not tightened against. Bigger constraints In theory, inflation results from an imbalance between the demand for goods and services and their supply. For now, there’s ample spare production capacity: even though global GDP is likely to surpass the pre-COVID level by the end of 2021, it will probably take a few years before it surpasses the pre-COVID trend (i.e. what the economy would be producing had COVID not occurred). There may have been some permanent destruction of supply but, at the same time, capacity in some sectors was likely boosted by the catalysation of technological change. A greater role for the digital economy means greater disinflationary pressures. A lagging recovery in employment is also likely to suppress inflation. The US economy still counts 8.4 million fewer jobs compared to February 2020 (based on the total number of non-farm payrolls*) and concerns about future job prospects are keeping consumer confidence in check today. That is likely to contribute to keeping the private sector savings rate above the pre-crisis norm. As spending on services normalises, we’ll spend less on goods than we have in a socially distanced world. Services prices will increase but are starting from very depressed levels; we think it will take a while for them to bounce back. Expectations: big hat, no cattle The biggest driver of inflation is inflation expectations, which are still well anchored. A market-based measure of inflation expectations, based on the difference in yield between nominal and inflation-protected five-year US government bonds, has risen back to normal levels. Although this measure doesn’t predict the five-year average very well, it is a decent guide to inflation over the next 12 months. Some commentators worry that it is in fact higher than where it has been since 2008, but we are more sanguine. Over the past decade, it has been too little inflation that has induced headaches among policymakers. They actively want to see inflation expectations move above their recent average. Rather than tightening policy to counter it, they would welcome it as a sign that their new efforts are having more success. Of course, they do not want to see inflation expectations rocket, but that’s not where we are today. Indeed, for all the recent speculation about runaway inflation, most market-derived measures of medium-term inflation haven’t risen significantly since early February. The American phrase ‘big hat, no cattle’ springs to mind. Keeping a close eye on the risks But we can’t ignore interest rate risk. Runaway inflation would cause central banks to tighten monetary policy sooner than expected, driving bond yields higher and equity valuations potentially lower. There is more upside risk to bond yields than downside, to our minds. Various analytical tools suggest to us that 10-year US Treasury yields are likely to end the year at around two percent, but with more stimulus in the pipe and inflation already running hot, it’s certainly plausible yields could overshoot. There are four main risks to our sanguine view on inflation: 1. Behavioural change – households and businesses save less than ever before because they now assume the Government will always bail them out. 2. Greater damage to the supply side of the economy than anticipated. 3. Unanticipated fiscal stimulus – the recently passed COVID relief bill was largely anticipated. There will be greater risks around another one if it is unprompted by deteriorating conditions. 4. Frontloaded rises in the US minimum wage to $15 an hour. We need to monitor for all of them. For the first, we need to keep a close eye on surveys and also credit demand. The extent to which households spend the $1,400 stimulus cheques will also be an important clue. We note that this most recent stimulus package, which was received in early March, resulted in a huge 21.1 percent month-on-month rise in personal incomes. While retail sales did also rise 9.8 percent in March compared to the previous month, retail is only a subsection of overall consumer spending, lots of which is also spent on services. In total, consumer spending only increased by a comparatively meagre 4.2 percent in March, suggesting that the majority of the rise in incomes from recent stimulus cheques have been saved rather than spent. Income growth will be expected to fall back to more normal levels going forward, and over the coming months we will be watching to see how much of and how quickly the recent build-up in savings will be drawn down as a result. If March’s data is anything to go by, it suggests that while a retail or services-driven consumption boom is likely to fuel the ongoing recovery, it is unlikely to be so great as to destabilise inflation.