After lying dormant for decades, high inflation returned in 2022. In Europe, it resulted from the energy prices surge following Russia’s invasion of Ukraine. In the US, it was the consequence of President Biden’s fiscal policy. Material impediments to supply chains amplified these effects across the globe.
Inflation is now on the way to levels that are normal. But once the genie is out of the bottle, it is hard to put back in. Will it return to a slumber or come back with a vengeance, like in the 1970s?
Modern monetary policy relies on the idea that keeping inflation expectations anchored around 2 per cent is key to inflation stability. Low expectations help to restrain firms’ price growth and workers wage demands. Small price shocks will only cause temporary deviations, as belief that inflation will return to 2 per cent helps to avoid second-round effects.
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But when consumers and firms live through a persistent burst of inflation, they become much more attentive to price pressures for many years thereafter. Increased sensitivity to and awareness of the trend means that firms and consumers may lead to significant second-round effects, even in response to small price shocks. That is how inflation persisted on and off for a decade in the 1970s.
Voters dislike rising costs even more than economists. Political parties in charge during the recent inflation surge either lost power at the following election or were significantly weakened politically.
The political incentives to keep inflation low are therefore strong everywhere. But in the United States, a combination of tariff, fiscal and monetary policy will lead to the return of inflation, similar to the consequences of President Nixon’s policies in the 1970s.
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US tariff policy will raise inflation directly. In the case of essential goods, importers can easily pass price rises on to US consumers, leading to a higher price level. But tariffs also restrict supply chains and impede supply side adjustment.
US immigration policy will also contribute to greater inflation over time. Important sectors of the US economy, whether farming or hospitality, rely on a considerable number of low wage immigrants to keep prices low. The current immigration policy will raise labour costs and inflation as a result.
Tariff and immigration policy restrict the supply side of the economy. At the same time, the fiscal policy legislation which has just passed through Congress will significantly raise demand in the US economy. Economics 101 says that when growth in demand significantly exceeds that of supply, the result is a significant rise in inflation. Indeed, the fiscal policy expansion during Covid-era supply chain tightness is what led to the recent burst of inflation in the US.
Finally, there is political pressure for the Federal Reserve chairman, Jerome Powell, to step down early. And there are concerns that any successor will risk lowering interest rates even if such a policy move would be inconsistent with low inflation. This would likely weaken the US dollar and add to inflationary pressure.
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The term US exceptionalism is used for good reason. The US economy has been incredibly resilient to many different shocks since the pandemic and has had a much better growth performance than any other G7 economy in the past two decades. That means it may be able to absorb some of these shocks without necessarily leading to inflation.
There are also other important mitigating factors. The theory of the optimal tariffs suggests that foreign producers are willing to pay for US market access by reducing profit margins rather than raising prices. Indeed, Japanese car producers reduced their US export prices by 18 per cent in response to the 25 per cent automobile tariff. Similarly, the current fiscal policy expansion relies on tax cuts rather than cash handouts. The direct effect on demand could be smaller and therefore less inflationary.
Nevertheless, turning up the dials on such a broad range of policies all at once is pushing your luck, even for an exceptionally resilient economy like the United States. The US economy could absorb one or two of these policy changes but implementing them all together is a recipe for higher inflation in the coming years.
It is often said that when the US sneezes, the world catches a cold. Will US policies lead to a return of inflation across the globe? As it turns out, these US policies will instead contribute to disinflation in European countries, including the UK.
US tariffs will create global excess capacity in manufactured goods. This will increase competition and therefore lower goods prices outside the US.
Migrants who were headed for the US may come to Europe instead. Indeed, given the significant demographic challenge, Europe needs more immigrants to address labour shortages. Spain has already seen a large inflow of migrants from Latin America. This has generated significant disinflationary growth there, as the growth in the supply side of the economy continues to outpace the demand side.
Financial markets tend to reward countries with stable, predictable and rules-based frameworks. In the EU and the UK, central bank independence is politically sacrosanct and getting inflation down is their main job. The pound and euro will likely continue their appreciating trends against the dollar. The euro may also become increasingly more acceptable as a reserve currency. Stronger currencies support broad-based disinflation, as many commodities are priced in US dollars.
Overall, US policies will drive a wedge in inflation developments across the world. US inflation will probably rise but fall elsewhere as a result.
In the 1970s, the US experienced persistent inflation for a decade. That was the result of Nixon’s tariffs, fiscal policy and political pressures on the Federal Reserve not to raise interest rates. The US dollar fell by a third during that decade. The Bundesbank, on the other hand, kept monetary policy restrictive during most of the 1970s, cementing its reputation for keeping inflation at bay.
While history doesn’t exactly repeat, it often rhymes. Inflation will probably return in the US but remain dormant in Europe.
Tomasz Wieladek is chief European macro strategist at the global asset manager T Rowe Price
