Are we heading towards permanent inflation?

Let’s start with the basics. How is permanent inflation defined?

Peter Lindahl: I have found no clear definition of permanent or persistent inflation. There is sometimes confusion between the high level of prices and rising prices. Anything below 2% is usually seen as low inflation and anything over is high. You can get very high inflation, which is around 5%, and that’s where we are now. Inflationary periods can last many years, but there’s always something that kills them. For example, if inflation is demand-driven, then the economic recession that typically comes after those periods will dampen inflation.

What would be an optimal level of inflation?

Tomas Hildebrandt: Economists are unanimous that zero inflation is not optimal, but a little is okay. So, what is a good level? It certainly isn’t 5% because then the erosion of money is too fast. There has been plenty of discussion around the magical level of 2%, which for decades was used as an anchor by the former Fed chair Paul Volcker in the fight against inflation. It was better than zero and it was achievable.

Is there any evidence of any economy heading towards high inflation?

Tomas Hildebrandt: What inflation means is income distribution within a country and across countries: there are some who benefit and others who must pay. This is typically seen in emerging countries where social structures, legal systems and governance are weaker. It is not possible to control inflation there in the same way as in Western countries.

Peter Lindahl: Many emerging economies already have very high inflation, like Turkey and Argentina, but it could be related to their currency falling and import prices rising by 20-30%. For the past three decades in the Western world, we have been in a low inflationary environment of around 2% in the US and Europe. It’ll be interesting to see whether we are moving into a period of a slightly higher inflation because rising inflation is difficult to stop, particularly if you get into an inflationary spiral which is what central banks are particularly afraid of right now.

What is happening in the US?

Peter Lindahl: In spring 2021, we started to see high inflation numbers coming out of the US, and then the same in Europe during the summer. Inflation was expected to rise, but it was surprising just how fast it happened. One of the triggers was very high wage growth, now rising at around 5% - the Fed was afraid of another wage inflation spiral that caused inflation in the 1970s.

Inflationary expectations have risen, but they’re not out of control in the US. Expectations are high, but not outrageously so. If they stay within a certain level, the central bank can move according to its plan. If inflation expectations were to rise much further, then they would have to move even faster, which could probably derail the economy into a recession next year.

Tomas Hildebrandt: The reaction to the coronavirus pandemic in the US was to strongly support households and consumption. It has worked, but businesses have run into shortages of labour, commodities and components. These have been amplified by disruptions in the global supply chains leading to higher production costs that companies have been able to pass on to consumer prices. Second round effects are now seen in rising wages to compensate for rising costs of living.

How much of an impact is the US’ situation having on Europe?

Tomas Hildebrandt: Inflation and inflation expectations have historically been on average about half a percentage higher in the US than in euro countries during the existence of the euro. Higher inflation in the US does not automatically translate to higher euro inflation. There are structural reasons behind that, but now rising energy prices seem to hit Europe harder. How sticky inflation will be depends on how vigorously the central banks will encounter it.

Peter Lindahl: There are some spill-over effects, but what we’re seeing in Europe, especially the euro area, is that a large share of the inflationary pressures is coming from the energy shock triggered by the war in Ukraine. Oil and natural gas prices are rising, so more than half of eurozone inflation comes from energy, while a smaller percentage comes from higher food prices. We are starting to see more of this structural and permanent inflationary pressure in Europe, but not in the same way as the US.

If you look at the long-term inflation expectations, the European Central Bank, the Bank of England and other central banks in Europe will have to follow the Fed by raising interest rates this year because they are at an ultra-low level, although they won’t raise them as high. Inflation is high right now, but the reasons are different to the US because their inflation is more demand-driven due to households having so much extra money.

Is the situation in Europe reflected in the Nordic economies or are there differences?

Peter Lindahl: It is reflected in the Nordics, but we have not seen as much of the negative energy shock as elsewhere. The Nordics are less dependent on natural gas than some other European economies because we have other energy sources for the manufacturing industry. In a way, the Nordics are more dynamic when it comes to absorbing the energy shock into the economy. Of course, the Nordic countries are very open economies so we see the same global inflationary forces.

Tomas Hildebrandt: If we touch upon the cyclical and structural factors in inflation, we can see that Finland and Sweden are not benefiting from the higher energy prices, while the net balance of oil-exporting Norway is more than both its neighbours. There are some psychological pressures to inflation, but they are not that different from those in other European countries. Most countries have been impacted by the higher energy prices in the same way when it comes to the structural issues.

The Nordic countries all have very strong governments and governance, as well as legal systems and central banks. There is a high level of trust in the monetary system and the functioning of the capital markets, so there should be no fears of erosion in their structural strength.

Interested to learn more? 

Infographic: How will inflation impact 2022?

The Inflation Puzzle

Tomas Hildebrandt is a senior portfolio manager for institutional clients. He is a member of Evli’s asset allocation team and is also working as a market strategist. Tomas joined Evli in 1996 and has been working in capital markets for nearly 30 years.

Peter Lindahl, M.Sc. (Econ.), chairman of Evli’s allocation team and the Head of Systematic Funds at Evli. Peter has worked in the finance industry since 1996 and started at Evli as a portfolio manager in 2000. He and his team manage factor funds.