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Inflation beyond the current spike

Markets weren’t too surprised to see a run-up in inflation in much of the world in 2021, aware that prices in a reopening economy would be compared with the low year-earlier prices that prevailed during COVID-19 lockdowns. But readings have been hotter than forecast as supply in a range of goods and even in labor has failed to keep up with resurgent demand.

With accommodative monetary and fiscal policies expected to remain in place for some time, could inflation at rates we’ve seen in 2021 persist in 2022 and beyond?

It’s not our base case. Our proprietary inflation forecast model, described in the recently published Vanguard research paper The Inflation Machine: How It Works and Where It’s Going, tells us that the U.S. core Consumer Price Index (CPI) will likely cool from recent readings above 4% toward the U.S. Federal Reserve’s 2% average inflation target by mid-2022. Our model then foresees a further uptick toward the end of 2022, assuming fiscal stimulus of about $500 billion is enacted this year.

“Fiscal stimulus, though, is a wild card,” said Asawari Sathe, a Vanguard U.S. economist and the paper’s lead author. “If we see $1 trillion or more in additional, unfunded fiscal spending enacted this year, core inflation could pick up more sustainably toward the end of 2022 or in 2023. This risk of persistently higher inflation is not fully anticipated by either the financial markets or the Federal Reserve forecasts and could lead the Fed to start raising short-term rates sooner than its present timetable of 2023.”


What’s been driving U.S. inflation higher

The Vanguard Economic and Market Outlook for 2021: Approaching the Dawn envisioned a possible “inflation scare” as spare capacity was used up and recovery from the pandemic continued. Ensuing supply constraints affected a wide range of goods, however, contributing to a greater-than-expected surge in inflation. (The surge in 2021 is reflected in the first panel of Figure 1 below.)

Nevertheless, most economists (including ours) believe that recent inflation readings that have more than doubled the Fed’s 2% target will prove transitory as supply issues are resolved and year-earlier numbers fade out of comparisons.

The second panel of Figure 1, which shows key inflation drivers pointing in different directions, supports that view. Although solid economic growth and accommodative Fed and government fiscal policies would argue for inflation staying persistently high, significant labor market slack and stable measures of inflation expectations—what businesses and consumers expect to pay in the future—suggest that price increases may ease.


Figure 1. The key drivers of U.S. inflation are sending mixed signals

Note: Data cover the 50 years ended June 1, 2021.

Sources: U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics, and Federal Reserve, using information from Refinitiv.


The challenges in forecasting inflation

Inflation forecasting is a complex endeavor that must consider broad inputs whose relative importance can vary over time. They include:

  • Cyclical factors such as growth and labor market slack.
  • Secular forces such as technology and globalization, which tend to keep costs—and, by extension, prices—from rising.
  • Fiscal and monetary policy.

With significant further stimulus being considered in Washington, fiscal policy is a particularly important factor right now in forecasting inflation.


Our model’s outlook for inflation: Higher than before the pandemic, but not runaway

We used our model to identify the potential impact of rising fiscal spending on inflation through the end of 2022. For that purpose, we have assumed that both the policy decisions and inflation expectation “shocks” originate in the third quarter of 2021.

“The output of all the scenarios we looked at suggest that risks are toward core inflation running higher than its pre-pandemic level of 2%, but that runaway inflation is not in the cards,” said Maximilian Wieland, a Vanguard investment strategist and co-author of the research paper.

In our baseline scenario, shown in Figure 2, we assume an additional $500 billion in fiscal stimulus and an increase of 20 basis points (bps) in inflation expectations. (A basis point is one-hundredth of a percentage point.) Our model suggests that would push core CPI to a year-over-year rate of 2.9% by the end of 2021. Continued stimulus and moderately greater inflation expectations would further push inflation—offset by stronger base effects (year-over-year comparisons with higher 2021 prices)—to 2.6% by year-end 2022.

In our downside scenario, we envision no additional stimulus and a minimal rise in inflation expectations; in our upside scenario, we bump up our estimate for additional fiscal stimulus to about $1.5 trillion and for inflation expectations by 25 bps; and our “Go Big” scenario factors in substantial net additional fiscal stimulus (about $3 trillion spent over a year) and a marked jump (about 50 bps) in inflation expectations.

In all our scenarios, the second and third quarters of 2022 suggest some weakness from baseline effects. But none of the scenarios results in the kind of runaway, 1970s-style inflation that some fear.


Figure 2. Scenarios for inflation based on potential fiscal stimulus

* The Fed’s 2% average inflation target is based on the core U.S. Personal Consumption Expenditures Price Index, which considers a more comprehensive array of goods and services than CPI does and can reweight expenditures as people substitute some goods and services for others.

Notes: The scenario data for the core CPI are Vanguard’s inflation machine model estimates for alternative fiscal stimulus spending. The downside scenario factors in $1.9 trillion in enacted fiscal stimulus and anticipates a 5 bps increase in the break-even inflation rate. The baseline scenario factors in $1.9 trillion in enacted fiscal stimulus and anticipates $500 billion in additional fiscal stimulus and a 20 bps increase in break-even inflation. The upside scenario factors in $1.9 trillion in enacted fiscal stimulus and anticipates $1.5 trillion in additional fiscal stimulus and a 25 bps increase in break-even inflation. The “Go Big” scenario factors in $1.9 trillion in enacted fiscal stimulus and anticipates $3 trillion in additional fiscal stimulus, a 50 bps increase in break-even inflation, and growth upside. All scenarios assume no change in the Fed’s monetary policy through 2022. We use the correlation between break-even inflation and long-term inflation expectations to adjust impacts in the model.

Sources: Estimates as of September 1, 2021, using data from Thomson Reuters Datastream, U.S. Bureau of Economic Analysis, and Moody’s Data Buffet, based on Vanguard’s inflation machine model.


Key takeaways for investors 

Although persistently higher inflation is not our base case, our model suggests that the consensus is too sanguine about inflation settling into its pre-pandemic trend of 2% in 2022.

If inflation readings continue to come in higher than expected, it could lead the Fed to move up its schedule for raising short-term interest rates. That might be good news for investors, as today’s low rates constrain longer-term portfolio returns.

Increased uncertainty about inflation highlights the importance of building a globally diversified portfolio, which gives investors exposure to regions with differing inflation environments.



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Publication date: September 2021

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