Deutsche Bank Issues Warning on Rising Inflation

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By Mark Kolakowski

Key Takeaways
Deutsche Bank projects a significant burst of inflation in 2022.
The report says the culprits are "off the charts" fiscal stimulus and "increased
tolerance for inflation" at the Federal Reserve.
If the Fed allows inflation to exceed 4%, history indicates that attempts to rein it in
will spark a "significant recession" and global "financial distress."

In a recent research paper, Deutsche Bank predicts that inflation is bound to accelerate,
as the result of the biggest policy shift in 40 years, in which governments have made
various social goals a bigger priority than controlling inflation and the rise of government
debt. The key issue discussed in the paper is whether this uptick in inflation is a passing
phenomenon, or a long-term issue with critical implications for the health of the global
economy. "Either way, higher inflation is coming and policymakers are about to face their
toughest battle in 40 years," Deutsche Bank warns.1

Below is a summary of the key points raised in this paper, which bears the title of
"Inflation: The defining macro story of this decade." This is the first in a new series of
occasional reports that Deutsche Bank plans to release under the banner of "What's in the
tails?" 2

'Paradigm Shift' in Policy

The report argues that macroeconomic policy in both the U.S. and other countries is
undergoing its greatest "paradigm shift" in 40 years. Fears of inflation have faded among
policymakers, and sovereign debt has soared above 100% of GDP in various large
industrial countries, "red-line levels" that were "unimaginable a decade ago."3

After the Global Financial Crisis of 2007-08, the high and rising levels of sovereign debt
became a key concern of policymakers. However, voters around the globe indicated that
their own chief concerns were about inequality and slow economic growth, leading to
gains for "populist parties and unconventional leaders." At the same time, continued low
inflation and low interest rates in the face of rapidly rising government debt led a growing
number of economists to become "more relaxed" about the levels of debt that countries
could sustain.3

'Increased Tolerance For Inflation'

Responsible macroeconomic policy traditionally has been constrained by concerns about
inflation and the levels of government debt, but these concerns are rapidly diminishing.
As a result, macro policy now is open to new goals that "go far beyond simply stabilizing
output across the business cycle."3

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In the U.S., the Federal Reserve typically used to raise interest rates when it forecasted
that inflation was on track to overshoot its target. The Fed now indicates that, instead, it
will not act preemptively in this fashion, preferring to wait until inflation actually has
exceeded its target. This shift in policy, in the view of the report, "only increases tolerance
for inflation," even as stimulative fiscal policy has gone "off the charts."3

'Over-Correction For Mistakes of 2008'

The report argues that "policymakers have over-corrected for the mistakes of 2008,"
when the U.S. fiscal stimulus enacted in response to the Financial Crisis and Great
Recession is now widely viewed as inadequate, leading to a unduly lengthy recovery. Not
counting the proposed infrastructure packages that are still under debate, the U.S. federal
government already has enacted stimulus packages in response to COVID-19 that total
about $5 trillion, or more than 25% of GDP.4

The U.S. federal deficit is likely to be about $3 trillion, roughly 14-15% of GDP in both
2020 and 2021, and remain in the mid-to-high single digit range thereafter. By
comparison, the deficit in 2009 was $1.8 trillion in 2020 dollars, or 10% of GDP.4

The last time that the U.S. federal government ran deficits that represented similar
percentages of GDP was during World War II, when the deficits ranged between 15% and
30% of GDP for four years, from 1942 to 1945. In the three immediate postwar years from
1946 to 1948, the annual inflation rates were, respectively, 8.4%, 14.6%, and 7.7%.5

Expect Inflation to Spike in 2022

The report projects that the economy will overheat in 2022, leading to a significant
increase in prices. The authors worry that the Fed will act too slowly to control inflation,
and that, when it does, greater financial and economic disruption will result than if it had
acted earlier. Among the likely effects will be a "significant recession" and a "chain of
financial distress around the world, particularly in emerging markets." 4

Pointing to recent history, the report indicates that the Fed has failed to achieve a soft
landing for the economy whenever it has pursued monetary tightening after allowing
inflation to exceed 4%. "Policymakers are about to enter a far more difficult world than
they have seen for several decades," the authors conclude.4

Inflation Already Accelerating

Subsequent to the release of the Deutsche Bank study, the U.S. Bureau of Labor Statistics
(BLS) reported that the Consumer Price Index For All Urban Consumers (CPI-U) ended
May 2021 at 5.0% above its value a year ago, for the largest 12-month increase since the
5.4% rise recorded in the period ending August 2008. In May 2021 alone, the index
jumped by 0.6% on a seasonally-adjusted basis.6 Compounded over the course of 12
months, this represents a 7.4% annualized rate of increase in the CPI-U.

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