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Should we fear inflation in 2021? Bank of Singapore's chief economist weighs in

Felicia Tan
Felicia Tan • 6 min read
Should we fear inflation in 2021? Bank of Singapore's chief economist weighs in
Bank of Singapore’s chief economist Mansoor Mohi-uddin says inflation is set to pick up again in the first half of 2021.
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Inflation is set to pick up again in the first half of 2021, says Bank of Singapore’s chief economist Mansoor Mohi-uddin in an economics research report.

This, he says, is caused by overall demand exceeding supply, which results in “too much money chasing too few goods”.

The rate of inflation last reached double digits in the 1970s in many major economies as the US government expanded spending on social programmes and the Vietnam War. The oil shocks in 1973 and 1979 further fuelled rises in prices.

Inflation rates were, however, crushed by the high interest rates imposed by Federal Reserve Chairman Paul Volcker in the 1980s despite political opposition.

In the 1990s, inflation was subdued as independent central banks set interest rates to keep consumer price rises limited to 2% a year, which lasted for three decades across all the major economies, says Mohi-uddin.

The first half of 2021 will, however, see a rise in inflation again, he notes.

“For example, the Fed’s target measure of inflation – changes in core personal consumption expenditure (PCE) prices - is likely to exceed the central bank’s 2% goal from 1.4% y-o-y currently,” he writes.

“PCE prices fell sharply in March and April at the start of the pandemic. But next spring, the weak readings will fall out of the year-on-year measure, lifting core PCE inflation in early 2021 towards 2.0% y-o-y.” he adds.

At the same time, the provision of Covid-19 vaccines may contribute to a burst of inflation in 2021 due to pent-up demand.

“Consumers are finally able to run-down savings built up during this year’s lockdowns… US savings rate soared to 33% of personal incomes in April as the government distributed stimulus cheques to households. Even now, the savings rate still remains above 13%, giving consumers ample funds to spend again,” he says.

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Is the pick-up in inflation temporary?

The near-term concern for investors is whether the rise in inflation in 2021 will be a temporary one, or one that leads to sustained price rises that may undermine risk assets, says Mohi-uddin.

The case rests on several factors.

First, the unprecedented monetary stimulus enacted in 2020 is far greater than that of the 2008 financial crisis.

The Fed’s and European central banks’ balance sheets have ballooned in 2020 as central banks printed money to support growth through quantitative easing, he says.

Moreover, commercial banks have much stronger balance sheets now compared to a decade ago, he adds.

“Thus, the financial sector is able to lend on the huge liquidity created by this year’s quantitative easing in loans to individuals and firms. In turn, stronger credit growth will support demand and spending and thus may start pushing consumer prices higher - in contrast to the aftermath of the 2008 financial crisis when commercial banks were unwilling to lend aggressively and focused instead on repairing their balance sheets.”

Second, fiscal stimulus to support demand has been far greater in 2020 compared to that of the 2008 financial crisis.

For instance, the Office for Budget Responsibility estimates that the UK government will log £394 billion ($706.0 billion) in deficit – around 20% of its GDP – its worst levels since 1944 during the second world war.

“Furthermore, G7 governments will not reduce fiscal deficits quickly after the pandemic as politicians have little support to make widespread cuts in public spending and tax increases that were imposed through ‘austerity’ policies after the 2008 crisis,” he says.

“Central banks may thus be inclined to keep borrowing costs low to enable governments to continue funding their huge budget deficits, adding to the risk of higher inflation in future,” he adds.

Third, inflation may pick up more than expected as the Fed is now seeking to overshoot its 2% target so that inflation averages around 2% over the course of the business cycle.

“The risk here is that as inflation picks up next year, the Fed will not start raising interest rates. Instead, the central bank will tolerate inflation overshooting its 2% target in the near term. But if inflation expectations also increase and individuals and firms expect consumer prices to rise by more than 2% for several years then higher inflation rates exceeding the Fed’s 2% target may become entrenched,” notes Mohi-uddin.

“The central bank would then have to play catch up, hiking interest rates rapidly to bring inflation back under control.”

Fourth, pressures on the supply side after the pandemic subsides may start to push consumer prices higher over time.

Costs for firms may increase if immigration curbs make it difficult to employ workers from abroad.

Governments may also encourage domestic companies to bring supply chains back home to increase domestic ‘resilience’ to future shocks, he says.

Finally, ageing societies in advanced and emerging economies will reduce prime working-age populations relative to children, students, pensioners and other dependents.

Then, firms may have to raise wages to attract and retain workers and subsequently pass on the costs to their customers.

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To combat inflation in the near-time, Mohi-uddin recommends investors hedge their portfolios with gold.

“But in the longer-term, the risk of higher inflation in 2021 leading to sustained price rises in subsequent years is still likely to be limited by independent central banks, unemployment and globalisation all curbing inflation in future,” he says.

Inflation is also unlikely to go past the Fed’s 2% target as “the central bank’s credibility in ensuring [that] inflation meets its 2% goal has resulted in America’s public expecting prices to be broadly stable, rising only around 2% each year, in line with the Fed’s inflation target”.

“Fed officials are very aware that the central bank’s credibility has been hard won by having to pursue very high double-digit interest rates in the 1980s to curb the high inflation rates of the 1970s. Thus, monetary policymakers will not want inflation to take off much beyond their 2% target in future. The Fed is independent so it can raise interest rates fast if the central bank feels inflation may become unanchored from its 2% goal,” he says.

The way Mohi-uddin sees it, inflation may remain under control for now as unemployment after the pandemic will make it difficult for employees to seek higher wages.

“The major central banks’ record of missing their 2% inflation targets over the last decade - even with very low unemployment rates - implies consumer price rises in future are unlikely to start exceeding 2% in a sustained manner,” he adds.

“In particular, the long-term trends that have pushed inflation down over the past few decades - technology automating jobs and thus tempering wage growth, globalisation leading to more competitive manufacturing and ageing populations shrinking consumer markets - are unlikely to be altered by the pandemic.”

Hence, the likely pick-up in inflation in 2021 may exceed central banks’ 2% targets temporarily, but will not lead to sustained price rises that will cause inflation to keep running above 2% for years afterwards.

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