Comments from Rupert Watson, Global Head of Economics & Dynamic Asset Allocation and the team 

This article looks to provide an insight on current affairs through an investment lense.

The Global Economics & Dynamic Asset Allocation team is responsible for creating the Mercer house view on the global economy and markets as well as dynamic asset allocation (DAA) decisions. The team is part of the Global Multi-Asset team led by Andrew McDougall. The team is led by Rupert Watson, Global Head of Economics & DAA, supported by Julius Bendikas, European Head of Economics & DAA and Cameron Systermans, Head of Multi Asset, Asia. The team is supported by seven analysts, each of whom have different specialties.  

Hear from the team

Regardless of the time horizon, the most important driver of inflation is the central banks’ target for those that have them. Monetary policy will be tight if inflation seems likely to be above target and loose if below. If tight, monetary policy settings will slow both growth and inflation and increase them if loose. Most of the developed world has 2% inflation targets and, if central banks adhere to that target, and are not swayed by political or other factors, inflation is likely to be at that level or close to it on average. This explains why inflation in much of the developed world has been near 2% over the last few decades. In some countries, such as Japan and, to some extent, the Eurozone, monetary policy has, until recently, been too tight. At the same time, it has been too loose in Turkey and elsewhere.

Although inflation will tend to converge towards 2% over time if monetary policy is implemented effectively, there are forces that could push inflation away from 2%, both in the short and medium term. Over the last couple of years, inflation has been a long way above target in much of the developed world – see Figure 1. The spike shown in the graph was caused by several different factors that all happened at once. First, the global economy rebounded strongly, especially in the US, as broad-based policy support boosted activity and led to over-heating. Second, supply chains were disrupted after the end of the COVID crisis. Third, commodities surged post both COVID and the Russian invasion of Ukraine. 

As we look forward, supply chains have returned to near normal, while commodity prices have fallen back. However, labour markets remain strong and wage growth, while softer, is still above levels consistent with inflation targets. As we discuss in our 2024 Economic and Market outlook, we expect labour markets to loosen further over the next 12–18 months, returning wage growth and thus inflation to near normal levels1.

A line chart comparing the global headline CPI in the US, UK, Eurozone, and Japan over the last twenty years is shown. The x-axis represents the time period, while the y-axis represents the percentage. The line for each country fluctuates throughout the time period, but all converge towards 2% in 2023.

Over the medium to longer term, there are both upside and downside risks to inflation. The slowdown of globalisation may lead to inflationary pressures. Given the experience of 2020, when supply chains grinded to a halt, as well as the more recent increase in tensions between the US and China, businesses may cease sourcing products based on price. Instead, they may be happy to pay a bit more if the supply chain is more secure. In addition, governments may force or incentivise domestic production in strategically sensitive sectors, leading to higher prices. Over the next few years, the energy transition could be inflationary if the likely significant increase in metal demand leads to a material increase in prices. Over time, the energy transition could be disinflationary as clean energy should become much cheaper than fossil fuel-based energy sources. The extent to which the energy transition is inflationary or deflationary will also differ by region, depending on the infrastructure needs and the cost of existing energy sources — in particular, natural gas. Natural gas is a lot more expensive in Europe than in the US, so the deflationary benefits will outweigh the inflationary forces a lot sooner in the former than the latter.

The development of Artificial Intelligence (AI) has the potential to be deflationary as any resultant boost to productivity should lower unit labour costs. Some commentators forecast that AI will have a huge impact on activity and productivity growth, while others forecast more limited impact. In addition, it is unclear when any productivity boost will begin. It is difficult to take a firm position on this issue, but we would lean in the direction of saying the ultimate impact will be large, although the timing of that remains uncertain. 

To conclude, we believe inflation will average 2% once the current inflation surge is over. Powerful forces could put upward or downward pressure on inflation over the medium term, pushing inflation a little bit above or below targets for periods of time. However, in the absence of major political-led change, we think that central banks will do whatever it takes to keep inflation near their 2% target.

Source

1. https://insightcommunity.mercer.com/research/655e210b17d1dc001d8d3e3d/Mercer_Economic_and_market_outlook_2024 

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