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March 10, 2022

Inflation to inflict more pain

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Julius Probst
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Food prices and political instability

Food and commodity prices continue to soar, exacerbated by the war in Ukraine. Historically, rapidly rising food prices have led to political instability in emerging markets. Analysts have even established a connection between food price surges and the Arab Spring anti-government protests that started in Egypt in 2010.

Commodity price shocks can therefore cause political violence and our chart below appears to back that theory. It shows a correlation between global food prices and fatalities from terrorism. 

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Surging electricity prices

Electricity prices have also surged as the war in Ukraine triggered an explosion in gas and oil prices. Our next chart compares electricity futures from one week before the Russian invasion to today for Germany, France and the Nordics.

While spot prices have risen across continental Europe, they are somewhat lower in the Nordics. The difference is particularly striking for Germany and France, indicating very elevated electricity prices for the next several months.

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Demand for commodities

Other commodity prices are also on the up. The following chart shows the number of commodities in so-called backwardation, meaning the spot price is higher than the futures price. This can occur when current demand for an asset outstrips that for contracts maturing in coming months through the futures market.

The table below shows long, short and net positions for several commodities. As you can see, the positioning has shifted substantially towards long positions, showing rising demand.

Investors have also been raising their long positions in the grain market in anticipation of higher prices. With Russia and Ukraine among the world’s largest wheat producers, the conflict has the potential to drive up prices significantly this year. 

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Oil price shocks and recession

To surging oil prices now and the price of West Texas Intermediate now exceeds USD125 a barrel, a peak that was last reached in 2008. Negative supply shocks typically raise the risk of recession since they lead to higher inflation and lower growth. As our next chart shows, almost every post-war recession in the US was preceded by an oil price surge. 

Bernanke, Gertler, and Watson explained in an influential paper that it’s not oil price shocks on their own that lead to lower output, but rather, the contractionary monetary policies in response to higher inflation. That is, the Federal Reserve usually responds to a commodity price shock by hiking rates, which puts additional downward pressure on output. With inflation already above 7%, it is hard to see how this time could be different.

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US economy overheats 

In general, monetary policy has been too expansionary since last autumn. Nominal GDP is way above its pre-pandemic trend, indicating that the current high inflation rate in the US is not just a supply-side and commodity problem, but also a result of excessive nominal demand. 

Moreover, a survey of professional forecasters now expects nominal GDP in 2022 to grow above 8.5% -- a much higher rate than before the pandemic. David Beckworth’s nominal GDP gap, a measure of actual nominal GDP relative to potential, has also recently turned positive and is now at 3%, another sign of an overheated US economy.

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Inflation expectations surge

This chart compares the market-implied change to the federal funds rate – the interest rate that banks charge each other – over the next 12 months together with the expected change in inflation based on a University of Michigan consumer survey.

It shows markets still expect about five rate hikes through the end of this year given the high inflation readings from the last few months. 

While inflation might surprise again on the upside due to surging commodity prices, growth might disappoint. This could put the Fed in a difficult situation as it try to strike the delicate balance of restraining inflation without choking off economic recovery.

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Mortgage rates rise

While the Fed’s policy rate is still at zero, there is little doubt that policymakers will hike rates several times throughout the year to fight high inflation. Moreover, corporate borrowing rates and mortgage rates have already increased ex-ante in anticipation of higher rates in the future. 

As this chart shows, the average 30-year US mortgage rate has more than doubled from a low of 1.5% in 2021 to about 3.75% right now. As borrowing costs surge, mortgage applications have fallen, which means the hot housing market may finally start to cool.

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Population growth and real interest rates

Our last chart shows the link between population growth and real interest rates in the US. You can see that as population growth slowed significantly in recent decades, real interest rates also turned negative. While 2021 is very much an outlier due to surging inflation, it is unlikely that the US and other advanced economies will experience a positive real interest rate environment in the years to come.

However, for most other economies, the correlation between population growth and real interest rates is less clear cut. For small countries, real interest rates are determined by global factors instead of domestic variables.

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