• Editor

Inflation worriers and warriors

Inflation continues to dominate the global investment agenda. Investors have become inflation worriers, mainly because persistently high inflation is forcing central banks to become inflation warriors.

Another reason for the focus on inflation is simply because developed economies have not seen anything like this in decades and responding to such high inflation falls outside the experience of most consumers, investors and indeed policymakers. In emerging markets like South Africa, it is a slightly different story. Inflation rates of 5% to 6% are not particularly unusual here. What is unusual is to have US inflation higher than South Africa’s as is currently the case.

Oiled up

One part of the inflation story is obviously the oil price. Much like other commodity prices, oil benefited from demand rebounding faster than supply (partly because supply is artificially constrained by OPEC quotas). More recently, Russia’s aggressive stance towards Ukraine and the risk of a war in the region have seen oil prices jump almost a third in the past three months. We don’t know where this is headed because no-one knows exactly what Russian President Putin’s end-goal is. Markets don’t like uncertainty, and the longer it persists, the longer the oil price can stay elevated while equity prices remain under pressure. In contrast, a resolution of the stand-off could see investors breathe out and oil prices decline.

Chart 1: Brent Crude oil price

Source: Refinitiv Datastream

Oil price increases feed directly into inflation statistics, but this is not inflation in the true sense. Yes, it increases the cost of living for consumers as well as the cost of doing business, but whether higher fuel prices cause inflation depends on whether businesses can pass on costs to consumers, and whether consumers can absorb those increases without reducing spending. In other words, rising oil prices in a strong economy with rising inflation (like the early 1970s) is a very different proposition than rising oil prices in a weak economy.

It is therefore important to understand the underlying economic picture.

Covid-19 was a shock to the global economy unlike anything previously experienced. Millions of people were forced to stay at home or did so voluntarily. Spending patterns, particularly in rich countries, shifted dramatically away from face-to-face services to goods. A well-worn example is that people cancelled gym memberships and bought home exercise equipment instead.

The other element to this story is monetary and particularly fiscal stimulus. Governments in rich countries were quick to lock down their economies in the face of the new virus, but they were also quick to provide financial support to workers and businesses. In poorer countries like South Africa, support was obviously on a much smaller scale. In the richest country of them all, the US, the support was historically large. Trillions of dollars were injected into the US economy through two large fiscal packages signed off by President Trump in 2020 and President Biden in early 2021. For the first time ever, total US household income increased during a recession. In other words, households had more money to spend, but fewer things to spend on. Some of this money was therefore saved, but a large portion was channelled into spending on goods which jumped well above pre-pandemic trends while spending in services languished below pre-pandemic trends.

Chart 2: US household income and spending

Source: Refinitiv Datastream

Goods are physical items that take up space. They need to be produced, transported and distributed. They often have long and complex supply chains. These were always prone to disruption, something that was not necessarily well understood before Covid. The lockdowns and quarantines provided disruption in spades and at every stage of the supply chain. This continues to this day, especially in China where a zero-Covid policy remains in force.

Labour shortages

The final ingredient is labour shortages. Right at the start of the pandemic, we said that behaviour will change in profound but unexpected ways. One of these unexpected changes is that large numbers of people have reassessed their relationship with work and have dropped out of the labour force, especially in the US where there are more job openings than unemployed people. Only time will tell if they will be lured back by higher wages and better working conditions.

The US experience matters greatly for the rest of the world since the US Federal Reserve’s policies impact financial markets in every corner of the globe.

The Fed has traditionally viewed inflation through the lens of the labour market. In other words, it believed that low unemployment tends to push up wages and ultimately consumer prices, a relationship known to economists as the Phillips Curve. The Phillips Curve relationship largely broke down over the last two decades due to global labour competition and technological change. If current labour shortages persist and lead to continuously rising wages, which in turn put upward pressure on prices, central banks are likely to get very nervous and interest rate increases could accelerate faster than currently priced in. At the extreme, interest rate increases aimed at cooling the economy can lead to a recession, an outcome neither the market nor central bankers want, but can still happen.

It also matters whether people believe the price increases will be once off or persistent. If the latter, those beliefs become self-fulfilling. Central banks also therefore place great importance on this notion of stable “inflation expectations”.

So far, the evidence is encouraging. Surveys in the U