The Inflation Comeback: Should Investors Be Worried?

Déjà Vu: Are We Repeating the Inflation Crisis of the 1970s?

After peaking at 11% year-on-year in 2022, inflation across the developed world had been steadily declining—until now. As central banks begin easing interest rates, inflation is once again creeping upward (see Chart 1). Between September and December, inflation rose from 2.1% to 2.5%.

The latest data reinforce concerns. In January, Britain reported a 3% year-on-year inflation rate, up from a recent low of 1.7%. Poland’s inflation rose to 5.3%, compared to 4.7% in December. While German inflation fell to 2.3%, it remains above the 1.6% recorded last summer. Meanwhile, U.S. consumer prices climbed 3% year-on-year, up from a low of 2.4%. With economic growth remaining resilient, some question whether central banks have acted prematurely in cutting rates. As Stanford economist John Cochrane put it, “Inflation is like cockroaches. When there are only a few left, [it] is not the time to let up.”

The Shadow of the 1970s Looms

Could the rich world be repeating the mistakes of the 1970s? Back then, policymakers suppressed inflation temporarily, only to see it roar back stronger. In the U.S., inflation peaked at 12% in 1974, dropped to 5% by 1976, but then surged to 15% by 1980. A failure to respond swiftly to the 1979 oil shock allowed inflation to spread across the economy. It wasn’t until the brutal early-1980s recession—deliberately engineered by central banks—that inflation was finally subdued.

Investors today remain uncertain about whether high inflation will return. Market indicators suggest the Federal Reserve will adopt looser monetary policy—and history shows that where the Fed leads, other central banks follow. Government bond yields have fallen in recent weeks, signaling reduced inflation concerns. However, a model from the Cleveland Fed indicates market expectations for inflation over the next year have risen from 2.2% in September to 2.7% today.

A Statistical Mirage or a Real Threat?

The renewed inflationary uptick has sparked debate among economists. Some argue the increase is a temporary illusion caused by statistical adjustments. Seasonal fluctuations—such as post-holiday price hikes—can distort data, and the lingering effects of the COVID-19 pandemic have further disrupted traditional inflation patterns. Additionally, commodity price volatility often causes short-term fluctuations, leading some analysts to dismiss the current inflation rise as a blip. For instance, Morgan Stanley economists suggest that recent wildfires in California may have temporarily driven up U.S. goods prices. Similarly, in January, countries like Belgium and Norway experienced sharp food price increases, potentially linked to trade war fears.

Yet, others warn that these explanations overlook a broader trend. Year-on-year inflation measures, which are less sensitive to seasonal distortions, clearly indicate rising prices. Moreover, a growing body of evidence suggests inflationary pressures are genuinely increasing. Alternative Macro Signals, a consultancy, analyzes millions of news articles to track inflation sentiment. Their “news inflation pressure index,” which has historically been a reliable predictor of official inflation data, has surged recently—particularly in the U.S.

Tight Labor Markets and Rising Wages Add Pressure

One key factor fueling inflation is the strength of labor markets. The OECD’s unemployment rate has remained below 5% for nearly three years. With businesses competing for workers, nominal wages across major economies are rising at an annual rate of over 4% (see Chart 2). However, productivity growth remains weak. Without increased output to offset higher labor costs, businesses have little choice but to pass those costs on to consumers, driving inflation higher.

This dynamic is particularly evident in the services sector, which spans everything from financial consulting to physical therapy. Service prices are now rising by 4% annually in leading economies—twice the pre-pandemic rate. Of the 18 developed nations that have reported January inflation data, 14 have seen an uptick in services inflation. In Portugal, it has climbed by one percentage point, while in Estonia, it has surged by 3.7 points.

Political Risks: Policies That Could Fan Inflation

Policymakers may inadvertently be adding fuel to the inflationary fire. While central bankers are expected to resist political pressure to lower interest rates prematurely, elected officials are another matter. Former U.S. President Donald Trump, for example, has proposed mass deportations of undocumented workers and higher tariffs—both of which could drive up prices by restricting labor supply and increasing costs for businesses.

Elsewhere, governments are adopting expansionary fiscal policies. Roughly 40% of developed-world governments are providing economic stimulus this year, as measured by changes in cyclically adjusted budget deficits. Britain’s latest budget increased infrastructure spending, while Italy recently enacted tax cuts. If Trump’s protectionist policies prompt retaliation, tariffs on American goods could further exacerbate inflation through rising import prices.

A Shift Toward a High-Inflation Mindset?

Compared to the pre-pandemic era, businesses and workers appear more attuned to inflation risks. A 2023 paper from the Bank for International Settlements described how economies can transition into a “high-inflation regime,” where inflation becomes a central concern for firms and employees. Once inflation expectations become entrenched, workers are quicker to demand higher wages, fearing continued price hikes.

Recent data suggest this shift may already be underway. Interest in inflation, as measured by Google search trends, is currently twice as high as it was before 2021. Consumer surveys reveal persistent inflation concerns despite actual declines in inflation rates. In December, the EU’s official inflation rate stood below 3%, yet European citizens expected prices to rise by 10% over the next year—double the expectation levels of the 2010s. A similar “inflation perception gap” is evident in the U.S. and Canada. Although Canadian inflation has remained at or below 2% since August, Canadians still expect it to reach 3% over the next year—higher than pre-pandemic expectations of 2.4%.

Time for Pest Control

Not long ago, central bankers celebrated their rapid success in curbing inflation. That achievement helped redeem their earlier misstep of reacting too slowly to the initial price surge. However, just as homeowners know all too well, cockroaches have a nasty habit of coming back. Inflation may prove just as resilient.