Commentary by Joseph H. Davis, Ph.D., Vanguard global chief economist

A useful term, base effects, helps explain dramatic increases in GDP and other barometers of activity as economies recover from the Covid-19 pandemic. The term places such indicators in the context of a recent anomaly—in this case the dark, early stages of the pandemic that depressed global economic activity.

Base effects help mask the reality that activity hasn’t yet reached pre-pandemic levels in most of the world, that labour markets are still notably lagging despite recent strength in some places, and that the threat from the disease itself remains high, especially in emerging markets. These amplified comparisons to previous weak numbers portray a US economy going gangbusters. Inflation is the next indicator to be roiled in this way.

It’s quite possible that base effects, as well as supply-and-demand imbalances brought about by the pandemic, could help propel the US Consumer Price Index (CPI) towards 4% or higher in May and core CPI, which excludes volatile food and energy prices, towards 3%. All else being equal, we’d expect inflation to fall back toward trend levels as base effects and a shortfall in supply fade out naturally.

But inflation, once it takes hold in consumers’ minds, has a particular habit of engendering more inflation. Beyond that, all else is not equal.

A real threat of persistent higher inflation

Sources: Vanguard assessment as at 13 April 2021, using data from the US Bureau of Labor Statistics, Federal Reserve Economic Data, Federal Reserve Bank of Atlanta, Federal Reserve Bank of New York, and the US Congressional Budget Office.

With the tepid recovery from the 2008 global financial crisis still fresh in mind, policymakers around the world have embraced fiscal and monetary policies as aggressive and accommodative as we’ve seen since World War II. Base effects will no doubt dissipate, and an inflation scare that we expect to play out in coming months will likely ease. But the threat of persistent higher inflation is real.

We’re watching for the extent to which any ramp-up in US fiscal spending beyond the $1.9 trillion American Rescue Plan Act (ARPA), enacted in March, may influence inflation psychology. Our enhanced inflation model—the subject of forthcoming Vanguard research—investigates, among other things, the degree to which inflation expectations can drive actual inflation.

That inflation expectations could have a self-fulfilling nature shouldn’t come as a surprise. As individuals and businesses expect to pay higher prices, they expect to be paid more themselves, through increased wages and price hikes on goods and services.

Fears of a self-perpetuating wage-price spiral are understandable, given the experience of older investors with runaway inflation in the 1970s. But many of the factors that have limited inflation, notably technology and globalisation, remain in force. And we expect central banks that will welcome a degree of inflation after a decade of ultra-low interest rates will also remain vigilant about its potentially harmful effects.

Higher core inflation under most scenarios

Notes: Our scenarios are based on the following assumptions: Downside—net neutral additional spending (any additional spending offset by revenues), marginal increase in inflation expectations; Baseline—$500 billion in fiscal spending above what has already been approved, a 10-basis-point increase in inflation expectations, and 7% GDP growth in 2021; Upside—$1.5 trillion in fiscal spending above what has already been approved, a 20-basis-point increase in inflation expectations, and 7% GDP growth in 2021; “Go big”—$3 trillion in fiscal spending above what has already been approved, a 50-basis-point increase in inflation expectations, and GDP growth above 7% in 2021. The “go big” scenario forecast dips below the upside forecast early in 2022 because of stronger base effects associated with the “go big” scenario in 2021.

Sources: Vanguard assessment as at 30 April 2021, using data from the US Bureau of Labor Statistics, Federal Reserve Economic Data, Federal Reserve Bank of Atlanta, Federal Reserve Bank of New York, and the US Congressional Budget Office.

Our model tested scenarios for fiscal spending, growth and inflation expectations. In our baseline scenario of $500 billion in fiscal spending (above the ARPA), a 10-basis-point increase in inflation expectations, and 7% GDP growth in 2021, core CPI would rise to 2.6% by the end of 20221. Our “go big” scenario of an additional $3 trillion in fiscal spending, a 50-basis-point increase in inflation expectations and even greater growth would see core CPI increasing to 3.0% in the same period. Both scenarios assume the Federal Reserve doesn’t raise its federal funds rate target before 2023.

If we’re right, that would mean a breach of 2% core inflation on a sustained basis starting around a year from now. And though we don’t anticipate a return to the runaway inflation of the 1970s, we do see risks modestly to the upside the further out we look. This could be positive for some corners of the market. Our recent research highlights how a lack of meaningful inflation contributed substantially to growth stocks’ outperformance over the last decade; a modest resurgence could help value stocks outperform2.

A sustained rise in inflation would eventually mean the Federal Reserve raising interest rates from near zero. (Vanguard economists Andrew Patterson and Adam Schickling recently discussed the conditions under which the Fed will likely raise rates.)

With rates having been so low for so long, adjusting to this new reality will take time. But our current low-rate environment constrains the prospects of longer-term portfolio returns, so escaping it may ultimately be good news for investors.

I’d like to thank Vanguard economists Asawari Sathe and Max Wieland for their invaluable contributions to this commentary.

Related links:

Why we don't see Fed rate hikes anytime soon

1 Our model accounts for annual fiscal spending on a net, or unfunded, basis. The extent to which tax increases might fund spending could change our growth assumptions and limit our model’s inflation forecasts. A basis point is one-hundredth of a percentage point.

2 Source: Global Macro Matters: Value versus growth stocks: The coming reversal of fortunes, Vanguard Research, April 2021. Value and growth are represented by a market-capitalisation-weighted index of companies in the bottom and top thirds of the Russell 1000 index, sorted by price/book ratios and reconstituted monthly, Data as at February 2021.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Reference in this document to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only.

Important information

This is an advertising document.

For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). In Switzerland for professional investors only. Not to be distributed to the public.

The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.  The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.

Issued in EEA by Vanguard Group (Ireland) Limited which is regulated in Ireland by the Central Bank of Ireland.
Issued in Switzerland by Vanguard Investments Switzerland GmbH.
Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2021 Vanguard Group (Ireland) Limited. All rights reserved.
© 2021 Vanguard Investments Switzerland GmbH. All rights reserved.
© 2021 Vanguard Asset Management, Limited. All rights reserved.