The Return of Inflation

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The U.S. economy is likely to avoid a 1970s-style wage-price spiral even as wages and inflation are rising at their highest rates in roughly 40 years.

"For a wage-price spiral to settle in, you need people to believe that inflation is going to increase indefinitely," said Gregory Daco, chief economist at consultancy EY-Parthenon. "We're not seeing that."

A wage-price spiral occurs when consumers expect higher prices to remain in place so they begin to demand higher wages to match. Businesses, in order to hire new employees and retain existing ones, have to comply, so they raise pay and pass on those higher labor costs to consumers through higher prices. Higher prices lead to higher wages, and as the spiral continues, economic conditions worsen.



Recent gains in pay and surging consumer prices have drawn comparisons to the high inflation and surging wages of the 1970s. At the time, wages and inflation accelerated to historic levels, leading the Federal Reserve to hike its federal funds rate to over 19%, an all-time high that contributed to two recessions in the early 1980s.

Still, there are signs that current conditions will not last. Consumers expect inflation will ease in the coming months, while markets expect the Federal Reserve's long-awaited rate hikes, which will raise borrowing costs and curb demand, are just around the corner.

A wage-price spiral remains a possibility, Daco said, but inflation and wage growth would need to accelerate and they currently look to be stabilizing.

With U.S. inflation at the highest level in four decades, what will the year ahead look like for global markets against a backdrop of evolving monetary policy and the continuing pandemic?

Shipping rates out of China have likely provided some relief to shippers, even if still elevated. Based on the Shanghai Shipping Exchange's China Containerized Freight Index, rates out of China fell 5.6% since the week of Feb. 11. This represents a rise of 1.3% from the start of 2022 but could indicate a slowdown in rate growth. Rates to the U.S. West Coast and Europe followed this trend, declining 6.1% and 5.6%, respectively, since mid-February, but still remaining up 6.4% and 8.1% since the beginning of the year.

Asia-Pacific sovereign ratings are demonstrating resilience amid health crises, disrupted supply chains, geopolitical strains, and weak economies. S&P Global Ratings expects most of the ratings to remain unchanged over the next one to two years, even as COVID-19 continues to weigh on government and corporate balance sheets.

The ECB could start preparing markets for monetary policy normalization as soon as March. This will depend on the set of new forecasts it receives ahead of its next meeting on energy prices, the euro exchange rate, and wage developments.

Before it raises rates, the ECB will have to phase out net asset purchases under the PEPP and APP. Given the ECB's current timelines, net purchases are unlikely to go to zero before September 2022. That would pave the way for a potential first rate hike in December 2022.

Balance sheet normalization will take time. S&P Global Ratings still expects the ECB to reinvest its PEPP holdings until the end of 2024, and the APP reinvestments could likely last longer than that. Given that the average duration of the ECB's bond portfolio is seven years, passive balance-sheet normalization could continue until 2031.

More Upbeat Inflation And GDP Developments Point To Earlier Monetary Policy Tightening

Last Thursday, the European Central Bank (ECB) opened the door to an earlier monetary policy normalization than it had foreseen last December. Inflation--already elevated because of energy prices—has clearly surprised on the upside in the past two months, while GDP recovered to pre-pandemic levels in Q4 2021, and the unemployment rate is back to its lowest on records. The ECB has acknowledged that the economic effects of the pandemic are continuing to diminish, so that the economy may reach full potential earlier than it previously expected. This may translate into higher prices more quickly than thought. With risks to price forecasts now on the upside, the ECB has given to understand that it is now unlikely to wait until 2024 to raise rates. S&P Global Ratings believes that this could lead the central bank to bring its rate normalization forward to the final quarter of 2022.

S&P Global Ratings Research expects global bond issuance to contract about 2% in 2022. The global bond issuance total surprised to the upside in 2021, edging out 2020's breakthrough growth to finish at $9 trillion. A particularly strong fourth quarter led to the 5.6% annual surge, after the year-to-date total fell just over 1% short of 2020's through September.

For 2022, fears have grown that the Federal Reserve could move too quickly, aggressively, or unpredictably in its fight with inflation over the coming months, potentially stymieing growth and earnings and exporting tighter monetary policy abroad. This is the key item markets appear to be watching, but our base-case assumption that interest rates will rise this year without becoming restrictive remains intact at this point.

However, risks have grown in the past three months. Other headwinds are still blowing, including still-high cash balances among larger firms, China's deleveraging policies, difficult comparisons with 2021 totals, and the return to trend economic growth. Geopolitical risks have also grown, and several key elections globally this year could bring more unpredictability.

Base metals rallied in the week starting Jan. 17 against a backdrop of rising Russia-Ukraine border tensions, higher inflation in major economies and market tightness.

The White House once again faces few options to respond to high oil prices as they race toward $90/b just two months after the Biden administration tapped emergency crude stocks.

Analysts expect the administration to consider the usual grab bag of policies and rhetoric that get brought out when domestic fuel prices rise.

Those include urging U.S. and OPEC drillers to pump more, tapping the Strategic Petroleum Reserve again, promoting anti-OPEC legislation in Congress, pushing the Federal Trade Commission to keep probing price gouging, and potentially bringing back talk of U.S. crude export restrictions.

Energy prices are the largest driver of inflation, which is testing President Joe Biden ahead of the tightly contested November mid-term elections that will determine control of Congress.

Crude prices have surged in recent weeks for a number of reasons related to geopolitical tensions, robust demand despite omicron outbreaks, uncertainty over OPEC spare capacity and an apparent lack of progress on restarting the Iran nuclear deal.

"The resulting pass-through to fuel prices doesn't merely risk economic slowdown and voter frustration," said Kevin Book, managing director of ClearView Energy Partners, in a Jan. 19 note. "It also can create headwinds to the White House green agenda: a President who campaigned on ending federal oil and gas leasing has continued to tread relatively lightly."



SPR savings erased

Biden took historic action Nov. 23 in ordering an SPR drawdown of 50 million barrels to bring down prices, something that had previously been reserved for physical supply disruptions. The Department of Energy has takers for a little over half of the barrels so far.

WTI crude futures dropped about $12/b in the week after the SPR announcement, but analysts saw omicron fears as the bigger driver in that price decline. WTI surpassed late November levels on Jan. 6, climbing nearly $7/b higher than when DOE announced the drawdown.