The creation of inflation

“Looking through” versus “it’s coming back”

25 August 2021 Stephen King, Senior Economic Adviser and Janet Henry, Global Chief Economist

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Inflation is back, at least temporarily. On either side of the Atlantic, either prices or wages (or both) are rising faster than they have done in many a year. Everyone, it seems, now has a view on inflation: some think it’s about to be unleashed on the unsuspecting masses, while others think it’s no more than a storm in a tea cup. We are facing inflationary uncertainty on a much bigger scale than witnessed in many decades.


Those who claim that inflation remains under control blame much of the recent rise on temporary “supply side” disruptions associated with the COVID-19 pandemic while pointing to an absence of any serious increase in inflationary expectations. We think this approach is problematic: expectations are often slow to respond to changing conditions and, in any case, are too volatile to be relied upon. Today, most economic forecasters’ inflation projections are simply anchored to existing inflation targets. If it all goes wrong, their projections will be among the last to adjust.

If inflation is about to rise sustainably, it will reflect fundamental changes in political economy. There are good reasons to worry. “Building back better” offers a throwback to Lyndon B Johnson’s ultimately inflationary “Great Society” in the late-60s; central banks have been given an increasing number of – at least in principle – conflicting objectives; quantitative easing has potentially unleashed a “backdoor” version of fiscal dominance; and, exacerbated by the COVID-19 pandemic, supply side conditions are no longer as favourable as they once were.

Still, a precise repeat of the inflationary 60s and 70s is unlikely. Automation continues to advance at a rapid pace. The “cost push” and “competing claims” models of inflation no longer resonate thanks to the decrease in unionisation, improved industrial relations, a more atomised labour market and the proliferation of job search “apps”. The internet has also made price transparency much greater than it once was. Unless these factors intensify, however, the risk is that once-tranquil price pressures build more sustainably.

Other issues are yet to be resolved. Will ageing populations (with an implied shortage of workers) lead to generalised inflation or, instead, a Japanese-style asset price deflation? Is looser fiscal policy without risk given huge lockdown-inspired increases in household savings which, with lockdowns coming to an end, can now be converted into big increases in consumer spending? Are price increases simply the market’s way of encouraging more supply and, in time, price declines, or are they a reflection of overly loose monetary conditions?

In economics, there are few “guarantees”. True, disinflationary pressures have been operating for decades, contributing (alongside slower productivity growth) to “lower for longer” interest rates. Yet, as with any process of induction, the past can only be an imprecise guide to the future. We have closely examined the conditions under which inflation is more likely to misbehave. Those conditions are more relevant now than in many a year. This is not to say that the forces of disinflation have disappeared but, instead, that they may no longer be sufficient to offset forces increasingly operating in the opposite direction. We employ a series of “scenarios” to evaluate the key risks surrounding a central “business as usual” view:

Scenario 1: Business as usual (or the “looking through it” scenario) – the most likely scenario given the many years of price stability achieved – and the inflation view we have had for the past year or so. Yet this has been increasingly undermined by the new economic realities.

Scenario 2: Early-90s Japan: confusing near-term inflation for long-term deflation – This scenario is possible but unlikely: the current crop of central bankers fear a Japanese outcome more than anything else.

Scenario 3: Inflation up, triggering both rising expectations and, eventually, a major policy reversal – The mirror image of scenario 2. The risks are uncomfortably high: the world has changed.

Scenario 4: Inflation up, financial repression – Still a low risk, but central bankers’ anti-inflation mettle has yet to be tested in current conditions. If they continue with QE and low rates simply to support government fiscal positions, the inflation genie could escape.

Scenario 5: The scattergun – A return to increased inflation divergence between nations. Increasingly likely given the slow pre-pandemic retreat from globalisation, the post-pandemic rebuilding of borders and barriers and varying fiscal burdens, and an increased prioritisation of goals other than price stability.

First published 23 August 2021.

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