Introduction

The global economy has been operating in a low inflation environment for the last decade or more, with central banks undershooting inflation targets (that usually centre around 2%). Low inflation has been driven by: globalisation forcing down the price of global goods, technology driving down costs in production and wages and a slower than expected economic recovery after the Global Financial Crisis. There were signs that inflation was starting to increase before the COVID-19 breakout as manufacturing activity was recovering and global growth was improving, and this is what central banks were trying to achieve.

The first round of lockdowns in 2020 resulted in deflation in parts of the world (like Australia) in June quarter 2020. Big falls in oil prices (from lower demand), government policies (like free childcare in Australia) and closures of some parts of the economy (from lockdowns) pushed some consumer prices down. However, deflation was short-lived as re-opening of economies led to a rise in activity. Fast-forward to a just over a year later, the concern is now around an inflation break-out with both consumer and producer price indicators recently printing to the higher side of expectations (see the chart below), especially in the US. This Econosights looks at some of the recent drivers of higher inflation, to determine whether the current rise in inflation is here to stay and whether it is going to become a problem for economic growth, central banks and and equity markets.

Coronavirus and inflation

Global goods prices have been rising steadily in 2021 from a few factors: a big rise in consumer demand for goods (consumers are cashed up from government fiscal transfers and can now unleash this spending as economies open up), higher energy prices (for gas, oil and coal) filtering into producer and consumer costs and manufacturing bottlenecks in production and shipping (as companies are struggling to meet the high level of consumer demand while also dealing with closures of factories due to coronavirus outbreaks). Most of these factors are likely to be temporary because they are related to disruptions from COVID-19.

Consumer spending should start rotating from goods to services as economies open up which will relieve pressure from goods inflation. There are some early signs that supply pressures are easing as global shipping costs look to be peaking but business PMI’s (Purchasing Managers Indices) are still showing high input and output costs. There is also the risk that production has been ramped up too much, just as consumers are shifting demand to services which could mean the potential for goods price deflation in the future!

Higher consumer services spending could lead to a spike in services prices as businesses respond to rising demand which will further add to inflation fears. So clearly, the risks to inflation are to the upside and the world has moved away from the pre-COVID low inflation environment. Consumer incomes are in a good shape and savings are higher compared to pre-COVID levels in developed countries, thanks to government fiscal transfers to households during the pandemic. In the US, the household savings rate is at 9.4%, compared to pre-COVID levels of around 7.5% in 2019. In Australia, the savings rate is at 9.7%, compared to a pre-COVID average of around 4.9% (see chart below). Cashed up consumers could lead to further persistent goods and services price rises. As well, it is less known if energy price inflation will slow. The movement away from fossil fuel energy towards renewables could lead to higher energy prices, at least until the infrastructure for renewables is more reliable.

US inflation concerns

US core inflation (as measured by the personal consumption deflator – the US Federal Reserve’s preferred inflation measure) lifted to 3.6% in September and has now been above 3% since April. This has been the biggest spike in core inflation since the early 1990’s (see the chart below) and well above the Federal Reserve’s 2% inflation target. Big rises in prices have occurred in used cars, airfares, hotels and car rentals. It is unlikely that these price rises will continue at the same rate going forward because they are all related to higher initial demand from re-opening of the economy. US housing costs have also been rising but this another COVID-related distortion as the rent moratoriums previously imposed by the US government to help consumers in lockdown are ceasing.

The impact of these one-offs on the inflation data is less evident in the “median inflation” measure which excludes outliers. The median inflation measure shows less of a rise in the consumer price index and was at 2.8% per annum according to the Federal Reserve Bank of Cleveland median inflation measure.

The latest Australian inflation data

The September quarter Australian inflation data showed that underlying inflation pressures are building. Underlying inflation is now tracking at 2.1% – the bottom end of the RBA’s 2-3% target band, for the first time since late 2015. Covid-related supply constraints were evident across many categories – in housing construction costs, audio and visual equipment and household furnishings. This is coming at a time when services prices are also going to start rising from the re-opening of the economy (see chart below). So, while the RBA may look through some of the rise in underlying inflation for now, price pressures are building and rate hikes are getting closer in Australia. We expect the first hike in interest rates to occur in November 2022.

Implications

In our view, the disruptions from COVID-19 are driving most of the price rises across the major economies. While these disruptions are likely to be temporary, this may take some months to become evident in the data which could make sharemarkets uncomfortable about a potential inflation breakout until then.

Most global central banks have been making the case that the current inflation scare is transitory, mainly for the reasons outlined in this note. But, the Bank of England, the Bank of Canada and the Reserve Bank of New Zealand have been more hawkish and are removing stimulus or tightening monetary policy faster than the other major central banks. Of course, there are country-specific factors that may cause individual central banks to change monetary policy accordingly.

While we are of the view that inflation is not about to become unsustainable (sustained price rises above 3% per annum in core terms), inflation will be higher over the next few years compared to the pre-COVID environment. The US Federal Reserve is likely to start hiking interest rates in the second half of 2022, if not earlier and global bond yields will continue to rise from here. Given the low starting point for bond yields, share markets and yields can still rise together for now, especially while the global economy re-opens and corporate profit growth is strong.

As well, moderately higher inflation is not always problematic. Inflation will be helpful in reducing the very high public debt burden post-COVID (rather than governments reducing spending or increasing taxes). High inflation becomes a big problem for consumers if wages don’t respond which is why it’s important to look at changes in real wages (total nominal wages less inflation).