Surprising inflation in the post-Covid world – 04/18/2023 – Bernardo Guimarães

Much attention has been directed to inflation in Europe and the United States. Why?

In the figure below, the solid line shows annual inflation in the United States for each quarter since 2020; the dotted lines show inflation forecasts for the following quarters.

The full line shows that inflation was around 2% per year until the beginning of 2021, when it starts to grow and reaches 8.5% per year in mid-2022. Today, the rate is falling and below 6 %.

The dotted lines show that forecasts were overly optimistic. Between early 2021 and mid-2022, the dotted lines are always below the solid line.

For example, at the end of the first quarter of 2021, inflation was around 2% and a fleeting increase to around 3% was expected. In fact, inflation in the following quarter was already at 5% and continued to rise for over a year.

The dotted lines from Q2 2021 onwards are always downwards. Inflation was rising, but analysts expected that from then on everything would be different: inflation would fall from the following quarter. It was like this for over a year.

This was the biggest mistake in predicting inflation in the United States in recent decades. It was difficult to predict the path of the macroeconomy in a scenario as atypical and full of uncertainties as that of 2021.

One implication is that market prices (like interest rates) embody much lower inflation expectations. When high inflation came, the interest rate in the United States rose much more than expected. Therefore, those who bought fixed-rate bonds before this increase in interest rates, such as the Silicon Valley Bank, lost a lot of money.

After much excessive optimism, inflation for the last quarter of 2022 finally matched forecasts. And so was inflation in the first quarter of that year.

Now, falling inflation and problem solved?

Those who follow the numbers believe that inflation will continue to fall in the coming quarters. In the scenario considered most likely by analysts, by the end of next year inflation will already be back to 2%.

However, in another scenario, inflation stabilizes at a higher level—say, around 4%.

Each of these scenarios has different implications for our economy.

In the first scenario, the interest rate soon falls; in the second, the US central bank will need to raise interest rates to bring inflation back to the desired level.

Increases in interest rates in developed countries reduce demand for goods and services there, which helps them fight inflation, but is reflected in lower demand for our exports.

In addition, higher interest rates in the United States make it less attractive to invest in other countries. This leads to higher interest rates for companies and governments in emerging countries and therefore less credit and direct investment here. It is estimated that an increase of 1% in the real interest rate in the United States will lead to an increase of close to 2% in interest rates in emerging countries, with a non-negligible risk of default.

With lower interest rates in the United States, investment in Brazil is more attractive and the real tends to appreciate. This logic explains much of the change in the exchange rate last week. A more appreciated real reduces the price of imported goods and eases the pressure on inflation.

For all that, news about inflation in the United States (and Europe) will continue to affect interest and exchange rates here.

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