Inflation is uncomfortably high and in the near term, there's unlikely to be much respite for central banks. But the outlook for 2023 and 2024 is shrouded in uncertainty, and inflation will hinge not just on energy prices but on shortterm factors like supply chain disruption, as well as the longer-term forces of deglobalisation and demographics

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Source: Shutterstock

Content

• Our base case
• High inflation scenario
• Low inflation scenario
• Longer-term inflation outlook
• Will structurally higher inflation lead to structurally higher interest rates?

Inflation remains one of the hottest economic topics of the moment, affecting households and companies and giving central bankers a very hard time. For a long time, central bankers had labelled accelerating inflation as ‘transitory’, attributing the rise to the reopening effects after Covid lockdowns. With inflation surging for the second year in a row, inflation could still be labelled as ‘transitory’ in the sense that it is mainly driven by global factors like the reopening of economies, supply chain frictions, and the war in Ukraine and its impact on energy and commodity prices. However, it is definitely not ‘transitory’ in the sense of being temporary. In the Western world, in particular, high inflation has become an enormous concern. Headline inflation rates like those seen in the 1970s will most likely be transitory, higher prices won’t.

Most central banks and many private sector forecasters have had their respective inflation forecasts wrong for a long time. The main reason for these forecasting errors has been energy and commodity prices, which have surged over the last year. However, forecasting errors were also related to the underestimation of pass-through effects, ie, the willingness and ability of companies to actually charge higher prices.

In the past, companies often had to squeeze their profit margins in order to maintain market share when faced with higher costs. Strong demand from consumers, higher savings, and relatively stable income developments, however, have given companies huge pricing power. Additionally, the astonishing surge in American home prices and the rapid feed-through into rents, which carry a one-third weighting in the US CPI basket, has provided additional upside impetus. Looking ahead, the shorter-term path for inflation will be highly dependent on energy and commodity price developments, pass-through effects, and wage developments.

Over the longer term, however, other factors will be more important in shaping the inflation outlook. Just think of the peak in globalisation (ie, less global trade, less downward pressure on global goods prices, reshoring or friendshoring), demographics and decarbonisation. We think that all these structural factors will push up inflation globally to higher levels than in the past decade. Higher wage growth in the near term will also add to inflation momentum.

While it is always tough to make predictions, we have developed three scenarios for inflation developments in the coming two years.

1 Our base case

In our base case, we're assuming that energy prices stay supported through 2022 but begin to ease through 2023, perhaps linked to a gradual de-escalation in the Russia-Ukraine war. As our chart below shows in year-on-year terms, energy prices will begin to exert a negative base effect on headline inflation from late this year.

Still, there are plenty of pipeline pressures and pass-through effects should keep core inflation elevated through the remainder of this year. Worker shortages in the US mean there are now almost two vacancies for every unemployed worker, and the resulting wage pressure will mean services inflation remains sticky. Rising house prices have also lifted US core inflation, but Federal Reserve rate hikes should begin to cool the housing market and demand for consumer loans. Weaker house price inflation (and even outright price falls) will begin to pull the rental components within CPI sharply downwards through 2023.

Meanwhile, improving supply chains should bring down new car prices in 2023 and 2024, and there are already signs that used car prices have topped out. Reduced consumer demand for goods, now services have reopened, will also help alleviate one source of last year's supply pressure. That, combined with weaker private consumption in the eurozone given higher energy/commodity prices, will reduce companies' ability to pass on higher costs. Demands for higher wages in Europe will only be partially met, keeping wage growth between 2% and 3% year-on-year.

The Fed takes rates slightly beyond neutral, but the European Central Bank proceeds more cautiously. In both cases, the normalisation process should end around the turn of the year and keep central banks in a 'wait-and-see' mode throughout most of 2023.

Three energy price scenarios and their resulting base effects

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Source: Macrobond, ING

Tags
Inflation Federal reserve Eurozone ECB

Disclaimer

This publication has been prepared by ING solely for information purposes irrespective of a particular user's means, financial situation or investment objectives. The information does not constitute investment recommendation, and nor is it investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Read more