Dubai: Is post-COVID-19 global economic recovery going to be dampened by a big surge in inflation?
Indications from both advanced and emerging economies point to rising inflation caused by input costs translating into rinsing factory gate inflation that could eventually lead to a flare up in consumer prices.
The price surge is also fueled by low interest rate monetary policies and fiscal expansion by governments around the world to revive COVID-hit economic growth.
Recent data from China showed May’s factory gate prices rose at their fastest annual pace in over 12 years due to surging commodity prices and supply chain disruptions.
The country’s producer price index (PPI) for May increased 9 per cent, according to the National Bureau of Statistics. China’s producer price index climbed by the most since 2017 in May, with everything from big-ticket items like oil and metal to components such as screws and cardboard shooting up.
Does higher PPI mean higher CPI?
The PPI measures price changes from the perspective of the seller and differs from the consumer price index (CPI) which measures price changes from the perspective of the buyer.
The transmission of producer price inflation to consumer price inflation is not always a straight line. There is always a lag between the two because of factors such as the level of demand in the market, producers’ margins and the cost absorption capacity of producers.
China’s PPI is yet to feed through to consumer inflation. Consumer prices rose 1.3 per cent in May - the biggest year-on-year increase in eight months - but came in below expectations for a 1.6 per cent gain. Consumer inflation remained well below the government's official target of around 3 per cent.
Export of inflation
Looking ahead, the worry is that if China’s PPI hovers at elevated levels for an extended period of time, which would create economic headaches as downstream firms, fail to absorb higher costs. There are already some signs Chinese factories, facing tight margins, are passing on higher raw material costs to overseas clients, which could reinforce the global inflation loop.
As investors around the world turn increasingly skittish on global inflation outlook, news from China could add to their worries. A steady surge in manufacturing inflation in China could simply mean, the country, literally global hub of manufacturing could emerge a wholesale exporter of inflation with higher prices on manufactured goods.
Is US forced to import inflation?
The US economy’s rebound from the pandemic is driving the biggest surge in inflation in nearly 13 years, with consumer prices rising in May by 5 per cent from a year ago.
May’s consumer prices in US excluding food and energy rose more than expected for the third month in a row as the US economy reopens, increasing by 0.7 per cent after surging 0.9 per cent in April.
The rising prices of Chinese manufactured goods have a significant impact on US consumer prices. A US gauge of prices for imported goods from China rose 1.8 per cent at the close of the first quarter of 2021 from a year ago, the biggest gain in almost nine years.
In May, core inflation in US jumped from 3 per cent to 3.8 per cent, reaching levels last seen in 1992, and running well above the Federal Reserve’s 2 per cent target.
America's trade balance in goods hit an all-time low in 2021 and imports from China alone comprise about a fifth of all US consumption of manufactured goods.
Given that China is the leading supplier for every import category for the United States, price rise in China is certain to reflect in US consumer prices. The top three import product categories for the US from China are Machinery & Electrical, followed by Miscellaneous, then Textiles.
From January to June 2020, these three categories made up a combined 50 per cent of China’s exports to the US and roughly 41 per cent of overall US imports.
Is the recent US inflation spike transitory?
“The bulk of May’s price rises continue to be driven by temporary shortages of goods and reopening demand for services - though rent increases were also firmer last month. The Fed is still likely to see inflation cooling again after the summer and thus refrain from tapering its quantitative easing until early 2022 when the labour market has recovered further,” said Mansoor Mohiuddin, Chief Economist, Bank of Singapore.
The Fed and the financial markets, at least for now, want to see the recent sharp increase in prices as ‘cyclical’ due to demand outstripping supply as the economy reopens and inflation should ease as goods shortages are resolved and service activity settles again at pre-pandemic levels.
While the Fed continues to insist that summer increases in inflation are likely to be temporary and longer-term inflation expectations remain anchored around the Fed’s 2 per cent target, the impact of rising factory prices in China on US consumer prices will become more visible in the months ahead.
Although Fed is in no hurry to taper its easy money policy until the desired economic growth and job creation is achieved, rising consumer prices are likely to keep the discussion alive through the current year.
Price trends in advanced economies
The sudden arrival of inflation as economies reboot following the COVID pandemic is emerging a major challenge for policymakers around the world. Although economists agree there is upward pressure on prices, there is no consensus on whether rising inflation is a temporary phenomenon or if price rises, signal the start of a sustained trend with major implications for workers and companies.
Recent data suggest prices are rising at different rates across the 38 countries of the OECD, which together account for about 60 per cent of the global economy. In the United States, annual inflation increased to 4.2 per cent in April from 2.6 per cent in March, while Canada's rate accelerated to 3.4 per cent from 2.2 per cent. Europe saw more modest increases in April, with inflation increasing to 1.6 per cent in the United Kingdom, 2 per cent in Germany, 1.2 per cent in France and 1.1 per cent in Italy.
Although the OECD agrees that inflation is edging up, in tandem with the Fed’s view, it expects the jump in inflation to fade by the end of the year as supply chains disrupted by the pandemic get back up to speed and production capacity returns to normal. With many people still out of work, the group's economists don't expect a cycle of wage hikes and price increases to materialise — despite evidence of a shortage of workers in some industries.
The emerging markets story
Inflation in emerging markets has been ticking up in recent months, but largely remained within tolerable limits, as many of these economies are yet to make substantial recovery from the pandemic shock.
While inflation in a number of EM countries have moved above the respective central bank’s target or target range, they are yet to hike in interest rates. However, rising prices along with bulging public debt levels are unnerving many central banks.
“Historically low inflation in emerging and frontier market allowed for supportive monetary policies during the pandemic, which, via lower yields, helped finance larger deficits. While many economists think that higher debt accumulation is warranted in DM due to exceptionally low rates, we believe that the argument in the case of EM and FM is more nuanced,” said Elina Ribakova, Deputy Chief Economist of the Institute of International Finance.
Unlike the US Federal Reserve, which has so far dismissed inflation as transitory, emerging market policymakers do not have that luxury of waiting. Many have kicked off interest rate cycles even before their economies recover from the pandemic devastation.
Clearly, with the rising global commodity prices and food prices, the region is also likely to face a gradual increase in prices in 2021.
Economists expect, the GCC with their currencies pegged to the US dollar and a significant weightage for imports from China, weakening of dollar against Chinese currency could mean some imported inflation finding its way into the region.
COVID-related contraction in economies resulting in large number of expatriates returning home has resulted in an overall demand slump for consumption goods.
While food prices are likely to edge up along with global price trends, housing, a key component of consumer price is likely to remain low. This segment, which makes up nearly 30 per cent on average in the region’s consumer basket, has been on decline during the past five years.
Factors such as robust supply in housing market combined with slower growth in expatriate population is likely to keep rents lower which will act as a counterweight to rising food price inflation.
Why is there a threat of general rise in price across the world?
Data from around the world suggest that prices are rising across the world due at different paces and due to varying reasons. Here are a few common threads that connect the global inflation.
Cheap money policy
The large amount of liquidity made available across most economies across the world to revive growth through low interest rates and large government spending through borrowed funds have been reflating the economies. In some cases, the policy is delivering the unintended consequence of more than desired levels of inflation.
Economic recovery after a deep slump is creating new demand that is resulting in a rise in commodity prices. Commodity price surges generally occur against the backdrop of a weaker dollar. This allows emerging currencies to strengthen, cushioning the price impact of imported commodities and other goods. Although commodity prices have doubled in the past one year, the emerging market currencies haven’t gained enough to compensate for the price gains resulting in higher inflation.
Liquidity driven super cycle
A synchronised rise in commodity prices are happening across the world, first time since 2008. While demand surge is one side of the story, the excess global liquidity is driving up the commodity prices as the same forces that drove up stock prices during the pandemic.
Global food prices rose for the 11th straight month in April to hit a near-seven year high, according to a United Nations food agency index. Sugar prices soared some 60 per cent year-on-year and cereal 26 per cent as economic reopening spurs demand. Crop producers from the United States to Brazil are experiencing difficult growing conditions, heaping pressure on policymakers, especially in countries where food makes up a large part of the inflation basket.
Markets are waking up to soaring factory-gate inflation in China. The transmission from PPI to CPI is not a straight line but there is little doubt the global inflation loop is being reinforced by Chinese manufacturers passing on higher raw material and component costs to overseas clients. China is still central to global inflation dynamics, but this time around, the country is importing inflation from the global economy and is now in the command seat to re-export that inflation abroad in rising prices of manufactured exports that are now in demand in developed markets.
In terms of purchasing power, inflation is the rate at which the value of a currency is falling and consequently the general level of prices for goods and services is rising.
Inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation. Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
Is inflation bad?
That depends what stage of the stage of economic growth/recovery cycle a country stands. In early stages of the cycle, moderate levels of inflation boosts demand, growth and employment, until it transforms into demand-pull, cost-push or wage price inflation.
Although inflation boosts asset prices in nominal terms, in real terms it is illusory and exchange rate depreciation combined with inflation can be of disastrous consequences to investors holding assets in foreign currencies that are vulnerable.
An increase in the supply of money is the root cause of inflation, though this can play out through different mechanisms in the economy. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, by legally devaluing currency, more (most commonly) by loaning new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market. In all such cases of money supply increase, the money loses its purchasing power.
Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy's production capacity. This increases demand and leads to price rises.
Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channeled into commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodity, costs for all kind of intermediate goods rise. These developments lead to higher cost for the finished product or service and work their way into rising consumer prices.
Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs/wages to maintain their standard of living. Their increased wages result in higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.
Measuring of inflation
Inflation is measured using varying benchmarks. Depending upon the selected set of goods and services used, multiple types of baskets of goods are calculated and tracked as price indexes. Most commonly used price indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
The Consumer Price Index
The CPI is a measure that examines the weighted average of prices of a basket of goods and services, which are of primary consumer needs. They include transportation, food, and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by individuals.
Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation.
The Wholesale Price Index
The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. While WPI items vary from one country to other, they mostly include items at the producer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing. Although many countries and organizations use WPI, many other countries, including the U.S., use a similar variant called the producer price index (PPI).
The Producer Price Index
The producer price index is a family of indexes that measures the average change in selling prices received by domestic producers of intermediate goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the CPI, which measures price changes from the perspective of the buyer.
What Is Core Inflation?
Core inflation is the change in the costs of goods and services but does not include those from the food and energy sectors. This measure of inflation excludes these items because their prices are much more volatile. Food and energy are necessary staples, meaning demand for them does not change much even as prices rise.
What is inflation expectation?
Inflation expectation is simply the rate at which people—consumers, businesses, investors—expect prices to rise in the future. They matter because actual inflation depends, in part, on what people expect it to be. If everyone expects prices to rise, say, 3 per cent over the next year, businesses will want to raise prices by (at least) 3 per cent, and workers will want similar-sized raises. If inflation expectations rise by one percentage point, actual inflation will tend to rise by one percentage point as well.
Inflation expectations is very important for setting monetary policy. Central banks aim to achieve maximum sustainable employment and price stability. Inflation targeting is based on anchoring inflation expectations on a pre-set target.