The annual inflation rate in the US accelerated to 9.1% in June of 2022, the highest since November of 1981, from 8.6% in May and above market forecasts of 8.8%. 

If this view is correct, it suggests persistently higher inflation than policymakers and markets are forecasting and, while policy rates and bond yields may come down in time as recessionary fears gather and headline inflation peaks, we are still likely to be looking at a future interest rate levels that are, on balance, higher than markets are supposing right now.

Surging inflation and tight labour markets seem to make a wage-price spiral almost inevitable in Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view. Those with the highest inflation and the tightest labour markets face the most risk. This would seem to put countries such as the US, UK, Canada and Australia at the forefront. Governments and central banks might argue that longer-term inflation expectations are anchored and will help dampen wage awards but we are more sceptical.

In the UK, for instance, longer-term inflation expectations seem to be in the region of 3.5%-4.0% from survey’s taken in May and June. But while that seems quite modest compared to current inflation of over 9%, it does not seem that workers are negotiating on this basis. This week an independent pay review body is set to give its recommendations to the government for public sector pay increases. Press stories suggest that this will come in at 5%. That’s already above these long-term inflation expectations. What’s more the government is expected to yield to this advice, despite originally wanting to give away no more than 2%.

This is because it fears that rejection of the pay reviews conclusion will lead to a wave of strikes. As it stands, even if public sector s are offered 5% there might still be strikes. Public sector s in the UK can use the tightness of the labour market to their advantage, while in countries with less isation, such as the US, workers themselves can clearly vote with their feet if they perceive they are being underpaid. Wageprice spirals threaten to blow away central banks hopes of bringing inflation back to target. As is usually the case, central banks predict that inflation will come back to around target levels (usually 2%) over the next few years.

The Bank of Canada is one such bank but, in its simulation last week of a wage-price spiral, it estimated that CPI inflation would be around 4% at the end of 2024 and not around its base case view for 2%. Mr. Steve Barrow thinks the 4% case is much more likely and the same goes for others, particularly those with tight labour markets like Canada. It already seems clear to us in the CPI data we see today that rising wage costs are supplanting the pressures that has come from areas such as energy, food and general supply chain difficulties.

Even if these – possibly temporary – cost pressures ease back, firms will still be left with a rising wage burden and that’s going to limit  the overall fall in inflation. The extent to which this happens will presumably depend on the proportion of firms’ costs that go to wages and hence the more service-orientated countries could see inflation remain somewhat elevated. Of course, future economic weakness will reign in some price pressure, but that will take time, particularly if recessions are devoid of a significant rise in unemployment, as seems likely to be the case.

What does all this mean for rates going forward? In purely cyclical terms policy rates will rise now and fall in the future as headline inflation peaks and recessions develop. But structurally, inflation is likely to be higher than it was before Covid. That’s a good thing in some ways as inflation was too low beforehand. It is also a good thing because the world may avoid continually falling into the liquidity trap. But the good news ends there as market adjustment to this new environment is likely to keep the rates market very volatile indeed.