Inflation remains front of mind for investors and policymakers alike. Prices are rising at a rate not seen in generations, confounding expectations that a broader reopening of the global economy would ease pressures. Instead, a perfect storm of disruption has impacted the supply side of the global economy, pushing prices higher.
Those disruptions are resistant to forecasting, making it impossible to project near-term inflation. We don’t know when Chinese lockdowns will end, helping the global supply chain to heal. And we don’t know when the war in Ukraine will end, easing pressure on tight global commodity markets.
Given these uncertainties, why are we increasingly confident that prices will eventually moderate? Because while we lack visibility on the supply side of the global economy, developments on the demand side are coming into clearer view.
Monetary Policy Affects Demand
Prices reflect the interaction between supply and demand. When demand outstrips supply, prices must rise to re-equilibrate the economy. Supply-side constraints, such as Chinese lockdowns or war-induced commodity shortages, are beyond the purview of monetary policy—central banks can’t solve those issues by changing interest rates.
What they can do is slow demand such that, even in an environment of constrained supply, price pressures abate. That means tightening monetary policy to slow growth to a rate consistent with the ability of the supply side of the economy to keep pace.
And that is exactly what central bankers are doing. The US Federal Reserve has raised rates 75 basis points since March and is likely to add another 150–200 basis points of hikes later this year. Central banks in Canada, Australia and New Zealand are also hiking, and the European Central Bank appears poised to do the same in the next few months. Only the Bank of Japan and the People’s Bank of China are unlikely to raise rates due to idiosyncratic developments in their countries. Even so, the global trajectory is clearly toward higher rates.
The catch is that monetary policy works with a lag. Once rates rise, it takes time for the economy to feel the full effect. We shouldn’t expect higher policy rates to translate immediately into lower demand, slower growth and an easing of inflationary pressures. But, as the year progresses, we expect growth to slow, bringing inflation gradually lower.
Consumers to Rotate Spending from Goods to Services
As part of that growth slowdown, we expect consumers to increasingly spend on services rather than goods. Much of this upcoming rotation is simply making up for lost time. During the height of the pandemic, many services were unavailable, compelling households to rotate their purchases into goods. We estimate that Americans bought more than US$1 trillion of “excess” goods beyond the long-term trend.
Another part of the upcoming rotation is a natural re-equilibration in an environment of higher prices. Because demand for goods has been so robust, and because goods trade has been particularly impacted by supply-chain disruptions, goods price inflation has soared—up nearly 20% year over year at its peak in the US (Display). That has made services comparatively affordable and thus more attractive, and we expect consumers to adjust their behavior accordingly.