I WAS on my usual weekend hawker rounds in PJ last week, when an elegant lady approached me: I am so glad to see you at places where ordinary people gather – check out the prices: everything is up with Chinese New Year around the corner; not just among hawkers but also in wet markets, among fish-mongers & chicken sellers, as well as in supermarkets and with street vendors.
Why is there inflation when there is supposed to be none? Hence, today’s piece about the outlook on inflation.
Inflation is bad
Inflation as we know it is the rapid, continuing rise in prices, which arbitrarily takes wealth away from savers, and devalue the value of income earned.
It’s not just the purchasing power of money that is eroded; it is the trust in a reliable future on which promises and contracts in a capitalist society depend.
As I recall from the early 1970s to the 1980s, more than 50% of consumers regard inflation or the rising cost of living as the single biggest problem facing them. However, by the 1990s, inflation seemed to have waned; and didn’t resurface until the 2010s.
Even though the post-financial crisis stimulative packages raise government debt prodigiously, and QE (quantitative easing – where trillions of new money are created) started to hit its stride. The stage appeared to be set for prices to surge, yet they did not. In the 2010s, world inflation stayed stubbornly below 2% a year. At its worst this spring, the threat of demand-sapping deflation loomed large, especially in the euro-area and Japan.
Pressure mounted for central banks to aim for inflation above the 2% target. With interest rates close to zero, it has become very hard for monetary policy to push inflation back up even to 2%. Still, in Europe in particular, inflationary expectations are on the rise.
I see three main factors at play: (1) the after-effects of the stimulus measures taken by governments to cope with the COVID-19 pandemic, (2) demographic shifts, and (3) changes in policymakers’ attitudes towards the economy. Central-bank balance sheets in US, Britain, Japan and the euro zone have risen by more than 20% of their combined GDP since the crises began, mostly to buy government debt.
This new money is paying for enormous stimulus programmes, including wage subsidies, furlough schemes and expanded welfare benefits that put money into pockets and purses.
As I see it, today, the private sector finds itself flush with cash as vaccinated economies reopen; households and firms may even go on a spending spree. That can result in a lot of money chasing goods and services that might not be in ample supply, resulting in a brief period of inflation that would tail off.
Still, most investors think this year’s inflation is more likely to be below the 2% most central banks target than above it.
I believe that the underlying driver of inflation is a combination of the public’s expectation of price rises (which can be self-fulfilling) and the health of the labour market.
Both currently point to low inflation even as US’s economy is expected to recover faster than most. Relatively high unemployment will give firms little incentive to increase people’s wages, and thus little need to raise prices. So, even if there is a spending boom, there will be plenty of economic slack around to accommodate it.
Second, in recent decades, the integration of China, Europe’s formerly communist East, and other emerging markets into the global trading system provided the world economy with millions of new workers. Increasingly, price rises to cover increased wages became a thing of the past.
It does seem, based on the recent experience of Japan (the rich country has aged the most), that inflation there has long been lower than anywhere else, despite Herculean efforts on the part of the Bank of Japan.
The third argument for fearing a return of inflation is political. It rests on the idea that governments and central banks are becoming more tolerant of inflation, and that they will become even more so as the pressure on government budgets rise (especially in US).
Back in the 1970s, inflation was tamed only after Paul Volcker proved the Fed’s commitment, by pushing America into recession to slow sharp price rises. This norm is weakening. After a long period of low inflation, people forget how awful it can be. A third of the rich world have not been born when average inflation last exceeded 5%.
Central bankers everywhere now admit that, as well as maintaining price stability, they are also trying to keep governments’ long-term-borrowing costs low, in order to facilitate fiscal stimulus.
But today, there is no broad consumer price inflation in sight. Indeed, the case for reflation in the world economy is getting stronger. A recovery from the pandemic that is untroubled by excessive inflation looks likely. But it is not guaranteed.
Is inflation dead?
Yet, an increasingly vocal band of dissenters thinks that the world could emerge from the pandemic into an era of higher inflation. Certainly, higher expectations of inflation is coming on.
Their arguments are hardly overwhelming, but neither are they empty. Because the stock of debt is so large and central-bank balance-sheets are so swollen. The rich world has come to take low inflation for granted.
Many economists think the West especially the euro zone, is heading the way of Japan, which fell into deflation in the 1990s and has since struggled to lift price rises far above zero. Today, the inflationistas’ arguments are stronger. Stuck at home, people have been unable to spend at all. But once they are vaccinated and liberated from the tyranny of Zoom, exuberant consumers may go on a spending spree that outpaces the ability of firms to restore and expand their capacity, causing prices to rise.
There are already signs of bottlenecks. However, the world should be able to manage such a temporary burst of inflation. Also, it would inflate away a modest amount of debt. Policymakers might even breathe a sigh of relief, especially in Japan and the euro zone, where prices are falling. Still, the odds of a more sustained period of inflation remain low.
The Fed’s new approach tolerates a pace of inflation above its current target of 2 per cent. US inflation is now running at 1.4 per cent. How long can the central bank continue its extraordinary run of bond buying to keep interest rates down and support the economy in an effort to push inflation higher?
Realistically, market expectations of inflation are on the rise. In the US and Germany, long-term inflation expectations have rebounded sharply. However, if the Fed keeps suppressing yields, inflation expectations can rise even more. Real yields – interest rates that strip out inflation, matter; its now stuck at well below zero.
A negative real rate occurs when inflation runs above nominal yields. Negative real yields will probably continue. Backing the Fed’s new approach is a view that the damage inflicted by the pandemic is such that restoring full levels of employment will take several years.
Entrenched secular forces of ageing populations, innovative technology and the global sourcing of labour and capital are disinflationary in nature and not seen as fading. The upshot is more central bank buying of bonds in order to prevent a sharp climb in long-term interest rates, while tolerating more inflation. This all explains why so many investors are bearish on the US dollar. However, a weaker dollar in turn boosts commodity prices, an important driver of inflation expectations; while it raises the cost of imported goods for US consumers and companies.
What then are we to do
Even as global inflation pressures remain muted, Europe’s concern continues to be: how to get inflation up? Of late, US$ weakness has complicated matters for both policy makers and investors in Europe.
Already, the euro is more than 8% up against the greenback this year, and near its highest level since April 2018. A stronger euro makes exports less competitive, potentially curbing economic growth. It would also make imports less expensive, and damp inflation. Eurozone’s slowdown in growth has raised concerns about a double-dip recession.
The faltering rebound, combined with a weak recovery in the labor market, is likely to weigh on inflation. The ECB aims to get inflation close to 2% over the medium term. But that may be a long time coming: currently, inflation is estimated to rise 1% in 2021, and 1.3% in 2022. Europe needs inflation to be rising more.
The best environment for risk assets is when inflation is low, but rising. Europe cannot afford a stronger euro, but there is not much it can do. Indeed, they are now the furthest away from their inflation target they’ve ever been.
Localised price increases in KL reflect, by and large, the inter-play of supply and demand imperfections in the market place.
Add on imperfect information & complex supply chains, markets – left on their own, are bound to act imperfectly in balancing supply and demand. Supply bottlenecks and constraints are a frequent problem. And, demand can be seasonal and even, erratic. Hence, prices move up & down. The balance gets worse during festivals. Consumers – within limits, have the choice to choose the markets they want. Best to engage in more competitive markets to bring about fair, competitive prices.
The more competition there is, the fairer the prices will be. In the end, when it involves profits, this is easier said than done; leaving the consumer holding (most of the time), the wrong “end of the stick”. That’s life. There is no running from some inflation, especially this Chinese New Year.
Former banker, Harvard-educated economist and British Chartered Scientist Prof Lin of Sunway University is the author of “Trying Troubled Times Amid Trauma & Tumult, 2017-2019” (Pearson, 2019). Feedback is most welcome. The views expressed here are the writer’s own.