2 High inflation scenario
There are several factors that could keep inflation higher for longer, and in this scenario we're assuming:
- The Russia-Ukraine war drags on for years, and Europe has to make the transition completely away from Russian energy and commodities. Oil prices end the year at $150/bbl if secondary sanctions are introduced on Russian crude. Gas prices for next winter go much higher if flows from Russia into Europe are significantly disrupted. But assuming energy prices don't continue to ratchet higher in subsequent years, at least not at the same pace, then we're still likely to get negative inflation base effects from oil/gas, albeit later than in our base case.
- China’s zero-Covid strategy continues for the foreseeable future, putting more pressure on supply chains, while the West is increasingly worried about a China-Russia axis. Consequently, Western economies try to re-shore more production to “home” markets.
- Labour market rigidities become more structural and with hostility to immigration, supply problems persist and workers develop an appetite for wage increases with more unionisation.
- Fiscal policy remains highly supportive, offsetting the impact of higher prices on disposable incomes.
Central banks, especially the Fed, will hike more aggressively this year but inflation fails to come down even with a bit of a slowdown/recession in 2023 (albeit one which doesn’t generate a pronounced increase in unemployment). That results in even more aggressive rate hikes, in a not-so-subtle attempt to bring about a sharp downturn – essentially a modern-day Volcker moment. Inflation is eventually lower, though not before 2024.
3 Low inflation scenario
Here, a significant de-escalation in the war facilitates a reopening between Russia and the West. Energy and commodity prices drop significantly. China loosens its zero-Covid strategy more quickly than expected, while also adopting Western vaccines to help insulate against future waves of infection. Supply chain frictions ease, particularly when combined with a swift reduction in durable goods demand as consumers rebalance towards services. Goods that saw swift price rises through 2021 see outright price falls, with some retailers grappling with excess inventory as delayed shipments arrive.
Meanwhile, the shortage of skilled workers is solved by increasing the participation rate in labour markets, which could reduce wage pressures. Central banks have overreacted in their policy normalisation, pushing many economies to the brink of recession by the turn of the year and fiscal policy turns restrictive again.
In this scenario, central banks implement the same normalisation as in the base case scenario, stopping rate hikes somewhat earlier and actually starting to cut rates again in the second half of 2023.
Three scenarios for inflation and policy rates
Source: Macrobond, ING
Longer-term inflation outlook
Over the last few decades, central bank credibility, new inflation targets and several global factors had brought inflation structurally down. In particular, globalisation and digitalisation were two enormous drivers of deflation or disinflation. Just looking at these structural trends, we think that the coming years will bring more upward pressure on prices. This is what we call
3D inflation, ie, inflation structurally driven by decarbonisation, deglobalisation and demographics.
Decarbonisation: The war in Ukraine will speed up the green transition in Europe and this decarbonisation is likely to be inflationary, at least in the initial stages. Investment in renewable energies will first bring additional demand for fossil fuels and commodities. The transition toward renewable energies is likely to push up prices initially before renewables and energy autonomy leads to much lower prices.
Also, as we try to move towards net-zero we are likely to see European governments incentivise action by raising and implementing carbon taxes, which could limit the scope for significant falls in energy prices. This is less likely to be a route in the US with the prospect of Republicans regaining control of Congress. At the same time, the move to renewables will significantly boost demand for key industrial and rare earth metals used to generate renewable energy and for battery storage, adding to costs and inflation pressures. Consequently, this is likely to argue for higher inflation in the near term, especially in Europe. The hope is this will mean greater energy security, at least in the shorter term, and fewer fluctuations in global energy prices, which should help to depress inflation pressures.
Deglobalisation: Businesses may look to re-shore activity as a combination of the pandemic and Russia’s invasion of Ukraine has highlighted major issues over the durability of supply chains. The purpose of offshoring was to reduce labour costs and allow economies of scale to drive down input costs. Ensuring security and stability of supplies over and above keeping costs low will mean price levels and inflation are likely to be higher and consequently lead to higher wages.
Demographics: This can affect inflation trends in a number of ways. Fast-growing populations mean the demand for food, housing, entertainment, and so on, is going to be growing more quickly, which could generate higher inflation. However, the composition of the population growth is also important. If it is via high childbirth rates this means more mouths to feed, but there won’t be an immediate positive impact on the supply capacity of the economy versus, say if population growth was primarily due to immigrant workers in their twenties and thirties.
Another way demographics impact inflation is that as people move through middle age and head toward retirement they tend to earn and spend less. One conclusion is that countries with faster-growing, younger populations are going to see more economic demand and greater inflation pressures than countries with slower population growth and rapid ageing of the population.
Data shows that the US has a younger population than Europe with a median age of 38.4 years versus 47.8 in Germany, 41.7 in France and 40.6 in the UK. In fact, Ireland is the only European country with a lower median age (37.8 years). At the same time, the US is experiencing more rapid population growth of 1% per year versus 0.1% in Germany, 0.2% in France and 0.6% in the UK. Ageing economies are increasingly experiencing labour shortages, which in turn could lead to higher wages.
Will structurally higher inflation lead to structurally higher interest rates?
Even if the current high headline inflation rates are not sustainable and will come down, the era of disinflation or deflation is clearly over. In the coming year, central banks will be facing structurally higher inflation rates than over the last two decades. The question will then be whether Western central banks will try to fight this structurally higher inflation with the same determination that they fought disinflation, knowing that their success could be as disappointing as over the last two decades. This time around, the impact on the real economy from tightening monetary policy too much could be much more adverse than it was in the fight against disinflation.
Our three inflation scenarios in full
Source: 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
