If last year’s life-under-a-pandemic experience was unusual for every human on the planet, this year’s recovery stands apart in the history of recoveries.
Normally the symptom of overheating in a dynamic economy reaching full speed, inflation this time reflects a weakened economy taken by surprise. It was hard for anyone at home under government support to believe, if not to dream, that a solution for living with a mutant virus would be found so quickly. It makes for the happy end to a science fiction movie, but in reality it also creates a new type of economic havoc.
The rush to reclaim the life of “before,” and in even bigger quantities, is meeting the constraints of a globalized world. Differences in vaccine availability around the world have resulted in a global upturn more sequenced than synchronized.
Bottlenecks in the shipping of key inputs and resource constraints are creating shortages. With people not yet ready, or able, or eager to come back to work, firms are signalling a willingness to raise wages to incentivize their return. In the U.S., the largest economy in the world and among the most advanced in terms of vaccinations, prices are rising.
This type of inflation will abate. It is not taking place anywhere near the peak of an expansion cycle, as serious inflation concerns would. Ample slack remains in the U.S. labor market, and labor shortages should ease in the fall. Supply chain bottlenecks, related to the good surprise of an early reopening, will resolve with time. The Fed remains calm and committed to keeping a watchful eye on undesirable inflation pressure; markets appear to understand the message. In the longer run, notable technological investments during the pandemic will help increase productivity, providing room for wage growth without accelerating inflation.
Europe’s recovery looks strong. Service activities are following in manufacturing’s steps, and the summer will see both engines of growth firing on all cylinders. Inflation is accelerating, driven by the same dynamics as in the U.S. before it. It will also prove to be a symptom of the stop-and-go economy that refuses to be stopped, rather than point to a need to slow down already. This time, fiscal policy has been done right. The coordinated spending financed by European institutions points to a new dawn for the economic union. There is a good chance it will defeat the forces of gravity in European growth. The rise in euro-denominated safe assets will also enhance the stability and depth of the region’s financial markets.
It is now emerging markets’ time to shine. China, catching up on vaccinations at light speed, is confirming its return as a global growth engine. It will likely continue to pull other emerging markets along with it, particularly in Asia, via increased trade.
Outside of Asia, emerging markets remain dragged down by pandemic headwinds and a lack of expansionary policy space. Expedited vaccine exports to the region will help them catch up, and loose global financial conditions will give them time to do so.
We raise the odds of our baseline scenario, “The Best of All Possible Worlds!,” from 50% to 60% for the coming 12-18 months. Strong growth with fading extraordinary inflation pressure supports a gradual rise in U.S. interest rates, which provides a good backdrop for risk assets, including equities and emerging markets. Rate differentials may boost the dollar temporarily, but only temporarily. Markets seem to be convinced but have made it clear they will take any new data as a test. Thus, the odds of “Inflation Anxiety” remain at 30%; however, those of “Gravity Prevails” are halved to 10%. We feel more assured than before that 2022 will be a memorable vintage.