In our base case, we see the inflation outlook moving through three phases of varying supply and demand pressures: 1) Messy data in the immediate crisis aftermath; 2) A disinflationary recovery in 2021 (U.S.: +1.6%, Eurozone: +0.9%) due to substantial slack in the economy and a swift rebound in supply; 3) A temporary inflation overshoot in 2022 (U.S.: 2.1%, Eurozone: 1.2%) following a recovery to pre-crisis activity amid gradual supply headwinds but no policy paradigm change on wages or fiscal and monetary policy.

What would it take for a scenario of persistently high inflation (probability: 15%) to materialize? We see a risk that supply-side issues, including rising unit labor costs amid weak productivity growth and the extent of the economy’s longer-lasting scarring, could be underestimated. 

While a 1970s wage-price spiral would be difficult to imagine, given labor unions’ loss of influence, a push for higher wages and more redistribution amid heightened social discontent, together with more state intervention in economic affairs and rising protectionist tendencies, could well exacerbate prevailing supply bottlenecks and lead to a notable and persistent acceleration in inflation. In such a situation, central bank complacency should be particularly monitored. Central banks could indeed be reluctant to engage in an abrupt and aggressive policy U-turn to rein in inflation given (i) a ‘recency’ bias towards a long period of subdued inflation, coupled with (ii) the U.S. Federal Reserve’s recent strategy switch to Average Inflation Targeting (AIT) and (iii) the fear of a major market tantrum. Under such circumstances, our model on long-term inflation projections suggests that inflation could reach 6.2% in the U.S., compared to 4.5% in the Eurozone, by 2024.