Inflation on the way back but markets should have no fear

Combination of stronger recovery and rising prices shows that the global economy is returning to some semblance of normality

They may seem like small fry but they make our world go around. Whether in Tesla cars, toasters or tumble dryers, computer chips are so integral to our daily lives that, without them, our world would grind to a halt.

So it’s a worry as the world gears up for a faster recovery that global demand for semiconductor chips is outstripping supply. It could be symptomatic of a more widespread supply-side shortage of key production goods, which might lead to increased prices and higher inflation.

The Organisation for Economic Cooperation and Development reports that inflation in the major economies rose to 2.4 per cent in March. Inflation is coming back, but it’s not the bogeyman that markets need to fear. Higher prices are a sign of economic vitality, of which the world has been in short supply since the Covid-19 crisis began.

The pandemic may be far from over, but the combination of stronger recovery and inflation shows the global economy is returning to some semblance of normality.

It’s not purely the pandemic which is to blame, although production dislocations due to lockdowns and factory shutdowns haven’t helped. As companies around the world slashed production during the early phase of the coronavirus crisis last year, chip makers were forced to scale back output as well.

Now, chip producers are playing catch-up, trying to keep pace with the surge in global demand for semiconductors as world economic activity bounces back.

With the International Monetary Fund projecting that global growth will accelerate to 6 per cent this year after a 3.3 per cent contraction in 2020, it’s no surprise the world semiconductor industry is facing volatile demand conditions, which could cause bottlenecks for key industries like carmakers, with their high use of chips.

Last week, German chip maker Infineon, warned up to 2.5 million cars might not be produced in the first half of 2021 due to supply chain shortages. With market conditions booming for cars and consumer electronics after such a long period of pent-up demand, chip producers are being forced to step up production, but it will take time to reach optimal capacity.

The Semiconductor Industry Association reports that, worldwide, sales rose 3.6 per cent during the first quarter of 2021, an increase of 17.8 per cent over the past 12 months. Although chip output is being cranked up, firms like Ford Motor are still warning car production will be affected in some plants until the shortage is resolved.

In the meantime, fine-tuning the balance between recovery and rising inflation expectations could prove challenging. There may be some short-term price distortions but global policymakers still need to err on the side of caution and keep monetary policy as loose as possible until the world fully recovers from the pandemic and sustainable growth is secured.

It wasn’t too long ago that policymakers were complaining inflation was too low and the global economy was in danger of slipping back into deflation, so the temptation to rush back into tightening should be avoided at all costs.

As yet, there are no signs of either demand-pull or costpush inflation surfacing. Global growth is bouncing back, but from an extremely weak, noninflationary base.

Global recovery needs nurturing, not cutting off in its prime. US Federal Reserve chair Jerome Powell is correct to give stronger growth the benefit of the doubt until there is a more convincing case for higher rates.

Global output gaps are still extremely negative, industrial capacity levels are slack and wage pressures remain low, given the fallout from the pandemic. The OECD estimates the global economy might be operating as much as 5.2 per cent below potential output levels, suggesting little or no inflation danger this year.

China’s producer prices may have surged 4.4 per cent year on year in March, but inflation risks remain benign with the consumer price index low at 0.4 per cent. Base effects mean the inflation rate will pick up in the coming months, but Beijing can afford to stay relaxed for now.

Until the Fed signals that the time is ripe for tightening, the world can rest easy. No interest rate rise in 2021 should be the equity market’s rallying cry.