The trillion-dollar inflation conundrum facing the world

MODERATE INFLATION IS AN ECONOMIC GOOD. IT BRINGS FORWARD INVESTMENT AND CONSUMPTION AND STIMULATES GROWTH. EXCESSIVE INFLATION IS A THREAT TO GROWTH AND SOCIAL STABILITY

THe Us inflation numbers came in above the consensus forecasts on Tuesday but bond yields edged down and Wall street hit another record. The recovery from the depths of pandemic-driven recession is producing confusing outcomes.

The March Us cPI, at 2.6 per cent, was slightly above the 2.5 per cent anticipated and the highest since 2012. Between February and March the rate was up 0.6 per cent against expectations of 0.5 per cent and was again the biggest increase in nearly nine years. core inflation, with energy and food prices stripped out, was 1.6 per cent, also ahead of expectations.

at face value, the confirmation that inflation seems to be accelerating should have shaken financial markets. Instead the s&P 500 and the technology stock-laden nasdaq both rose slightly to post records, although the more industrially-flavoured Dow Jones Index slipped marginally.

Bond yields edged down, although that might be attributable as much to the success of a closely-watched auction of $Us24 billion ($31.4 billion) of 30-year Treasury bonds as it was to the inflation data. a succession of Treasury bond and note auctions over the next few weeks will test bond investors’ convictions about the inflation outlook.

The problem with assigning too much significance to economic data at present is that a year ago the pandemic was crushing global economic activity.

In March, april and May last year the Us inflation rate, already modest, fell as the economy closed down. The rest of the developed world had a similar experience.

That means there are what economists would call “base effects,” a fancy way of saying that the starting points for comparisons have been distorted by the worst of the pandemic’s impacts this time last year. There are also some distortions being generated by either new or fading stimulus measures – in the Us the most recent $Us1.9 trillion of stimulus measures, including $Us1400 cash giveaways to households. as this year progresses, emergency aid provided to businesses and households will, as is the case here, be withdrawn.

attempts to extrapolate the March data into a narrative of structurally increased inflation are, therefore, likely to be misleading until clearer air is reached in June and beyond. The Us Federal reserve Board, its peers elsewhere and the “doves” in the bond market believe that, while inflation might spike over the next couple of months to something above 3 per cent, that will be a transitory phenomenon and the rate will decline as the base effects wash through. Indeed, monetary policies in the Us and australia are predicated on that scenario for inflation.

If they are materially wrong – if inflation were to continue to accelerate and was tracking closer to three per cent than two per cent at year-end – central banks would face a dilemma and probably meltdowns in markets whose valuations are supported primarily by the assumption that rates in the Us and other major economies will remain negligible for years. The margins between central bank success and failure are small.

Developed world economies and their central banks have experienced stubbornly sluggish inflation since the 2008 financial crisis. For most of that period the fear has been of disinflation and central banks have tried novel and highly-expansionary policies, unsuccessfully, to ignite a spark.

Moderate inflation is an economic good. It brings forward investment and consumption and stimulates growth. excessive inflation is a threat to growth and social stability. It is regressive; it undermines the value of savings and currencies; it increases the cost of living and, through increased wage and salary costs, undermines productivity and competitiveness. It also forces central banks to raise interest rates, which in the current debt-swollen environment, would cause significant financial harm to households, businesses and government finances.

What the Fed, and the reserve Bank, are striving for is just enough inflation – around two per cent on average. as the past dozen years have demonstrated, however, that’s easier said than achieved. The task in hand is made more complicated because of the difficulty in differentiating between the transitory and structural effects of the pandemic.

supply chain disruptions, overlaid by unusual events like the recent blockage of the suez canal, or the storms in Texas that wiped out its power and disrupted fuel supplies, or the early dysfunction in vaccine roll-outs and the delay to a resumption of more normal global activity, could be either or both.

There is a shortage of containers, computer chips and other manufactured goods because of the effects of the pandemic on global shipping and business planning, which has been disrupted by, initially, the depth of the dive in economic activity and, now, the rate at which economies have surged back. some of those impacts will wash away quite quickly but others, like the reshoring of supply chains to protect economies from another pandemic, or in response to the growing tensions between china and the Us and its allies, might be structural.

The weight of the dramatic increases in deficits and debt from the pandemic actions of central banks and governments and changes to workplaces and economies will influence economic outcomes for years, even decades, to come. In the circumstances, it isn’t hard to see why opinion on the outlook for inflation and the future of interest rates is divided quite distinctly between the doves, which include central banks, and the hawks, mainly bond investors and sharemarket pessimists. The actual outcome matters for economies, businesses and households and will be reflected, probably ahead of the actual data, in financial markets.

Market interest rates have, despite central bank interventions, been rising this year but remain at historically low levels and have continued to support the inflation of share prices even at historically-stretched valuations.

should it appear that the rise in inflation from its pandemic lows isn’t a passing phenomenon but is becoming entrenched, bond yields will surge and markets will tank, potentially quite violently. The outlook for inflation is the most disruptive threat to financial markets since the financial crisis more than a decade ago.

For the moment the policymakers can take comfort from the opacity of the numbers and the aberrational reference points provided by the worst of the economic effects of the pandemic. They can attribute relatively high levels of inflation to stimulus that will fade; pent-up consumerism that will soon be sated and stimulus measures that will soon end.

as vaccines roll out and economies find their “new normal,” however, the quality of the numbers will harden and the multi-trillion dollar questions about the sustainability of the massively stimulatory monetary and fiscal policy settings will loom ever-larger.