Examining good and bad inflation

For once, central banks might be right about price rises. Inflation may not rise so rapidly and sharply that they will need to increase interest rates any time soon.

| 5 min read

Investors and market commentators tend to like asset inflation. When shares, bonds and property prices go up their investments perform.

A bit of goods and services inflation can also be acceptable. If general inflation is around 2%, the level most central banks want to promote, companies have some pricing power, profits and turnover can grow and the mood towards share and property investing can stay positive.

If the prices of goods and services start to fall equity markets can take fright, fearing deflation will stalk the land and undermine prosperous businesses. If prices rise too much, bond markets go into a spin.

Investors expect central banks to respond to too much inflation by hiking interest rates – and trying to rein in credit. Too much inflation hits equities as well as bonds. An economy will be put into slowdown or recession to cure inflation, hitting dividends and profits.

Boom, bust, repeat

In the last half century, the boom and bust cycle was common in advanced countries. Economies expanded and equities rose – then inflation forced up interest rates. First bonds fell, then shares fell as the economy slowed or declined again.

In this century, people talked of the new moderation, hoping that boom and bust was a thing of the past. A long upswing for most of the first decade was then ended by the great banking crash, only to be followed by another long recovery period. This was prematurely ended by the measures taken to combat the Covid-19 pandemic, before inflation had become a problem or before central banks thought they needed to rein in lending.

Today we are witnessing an unprecedented monetary expansion, allied to ultra-low interest rates. So far, inflation has remained very low, leaving governments and their central banks free to promote recovery and growth with aggressive monetary and fiscal policies. Governments are spending and borrowing on a grand scale whilst central banks are buying up huge quantities of the state debt in their country which makes it easy for governments to carry on borrowing.

Inflation outlook

Most commentators and the central banks expect inflation to rise from the very low levels it hit in March and April last year. Then, the collapse of economic activity and the prevalent lockdowns took inflation down to nothing in most advanced economies. Energy and commodity prices fell away as demand contracted severely. In recent weeks, there has been some revival, but inflation is still below the 2% target in the Euro area, the US, Japan and the UK. Inflation in the UK and the Euro area remains below 1% and Japanese prices are still falling. So why all the inflationary worries?

It is true inflation expectations have risen a bit. In the UK people expect inflation to run above 3%, ahead of the Bank of England’s target. Euro area expectations are still below 2%, and the US is around the 2% target.

Meanwhile, we are seeing some large price rises in certain markets. Some manufactures are in short supply. There have been prices rises of around 20% for various semiconductors, as the world’s factories try to source more. The oil price has risen by more than 50% from the levels of the summer of 2020, though this gets them back to where they were for some of 2019. Chinese rebar steel is more expensive than it was for much of 2019, and well up on the lows hit in 2020. Rice and corn have risen substantially in recent months and are well up on 2019. Copper has risen strongly from the pandemic lows to well above 2019 averages. Rare earths have gone up, with China restricting supply. There is a shortage of containers available for trade, with the Freightos Baltic Index nearly doubling since November 2020.

Spending splurge

Some say that when the advanced countries end lockdowns there will be a surge of spending from the many people who have kept well-paid jobs and saved money whilst at home. They will want to travel, return to hotels and restaurants, book entertainment and spend on sports. Might this spill over into price rises from businesses that have built up debts during the periods of closure? Could we see any upward pressures from services inflation, following energy and goods?

So far, the authorities are relaxed that there will not be an inflationary spiral. The first-round effect of recovery may be sharp rises in particular products and markets where supply is short. There need to be increased investments in everything from batteries to semiconductors and from rare earths to renewable energy to meet new demands.

There is less likely to be a second-round surge in wages, as there are all too many people out of work or hoping their jobs will revive as they stay at home on furlough or short-term working schemes. We should expect a continuing pattern of eye-catching rises in some prices coupled with difficult conditions in sectors damaged by social distancing and struggling with accumulated debts. For once, the central banks might be right that the rise in inflation will not trigger too fast and severe an inflation that needs higher short-term rates to correct anytime soon.

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Examining good and bad inflation

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