Food & energy are the main drivers of the rise in inflation right now, although price pressures are broader in parts of Asia and Australia.
The AMP’s Dr Shane Oliver says inflation and stagflation worries over the next few months will add to the volatile ride for financial assets.
"However, our assessment is that inflation will decline as growth slows and as oil prices fall in the next six months. As a result market expectations of interest rate hikes are overblown. And signs of lower inflation and lower bond yields should help share markets to rebound from later this year."
This week he looks at the rising dangers (for the moment) from higher inflation.
Concerns about the global credit crunch and the US housing slump have been supplanted by worries about global inflation.
This is evident in surging bond yields and tough anti-inflation talk from central banks.
For investors rising inflation is bad news, particularly if it becomes entrenched.
High inflation undermines real asset values, pushes up the yields investors require to invest, reduces the quality of company earnings, distorts economic decision making and ultimately leads to lower economic growth & rising unemployment. But how real is the threat?
Reasons for concern
While today’s inflation rates are way below the double digit levels of the mid-1970s, there are reasons for concern.
Inflation is above target in most rich countries, it is up virtually everywhere & it is leading to a rise in inflation expectations which threatens second round effects.
Inflation is up virtually everywhere.
Key drivers
Surging food and energy prices are the common factor behind rising inflation worldwide. Eg, in the G7 economies average headline inflation is above 3% but core inflation (i.e., excluding food & energy) is still around 2%.
However, in Australia, the problem has been broader than just oil and food. Inflation excluding petrol and food was 3.2% over the year to the March quarter and the Reserve Bank’s measure of underlying inflation was running at 4.3%.
Nor can imported inflation be blamed – prices for items determined in globally rose 3.3% over the year to March whereas prices for items determined in the domestic economy rose by 5%.
It would seem that the boost to national income from surging commodity prices has flowed through to domestic spending which has allowed price increases to flow through in a broader range of areas. Asia has also seen a more broad based pick-up inflation.
Higher food prices have had a greater impact because they typically have a 30% weight in Asian consumer price indices (versus 15% in rich countries).
More fundamentally though the combination of strong demand, waning excess capacity from the late 1990s Asian crisis and undervalued exchange rates have seen underlying inflation rise as well in several Asian countries, although not so far in China.
Reasons to expect inflation to fall over the year ahead
Inflation is likely to remain high over the next few months. This and attendant stagflation talk is likely to provide an ongoing source of jitters for share markets in the very short term. However, it’s hard to see it going too much further.
The first thing to note is that, despite the surge in food and energy prices which also occurred in the 1970s there are big differences between now and then which should prevent high inflation becoming entrenched.
We haven’t seen the huge productivity zapping expansion in government that occurred into the 1970s.
The global economy is now far more competitive following the end of the Cold War.
Labour markets are generally deregulated, union membership is down sharply and centralised wage setting in Australia is a thing of the past. Independent central banks have taken monetary policy away from politicians and inflation targeting helps anchor long term inflation expectations.
And financial market deregulation now means the consequences of allowing high inflation become quickly apparent in higher interest rates or a falling currency.
Secondly, the downturn in global growth now underway will likely lead to lower inflation over the next year as excess capacity is freed up.
Every major economic downturn in recent times has led to lower inflation. This is illustrated for the US in the next chart.
This will also be the case in Australia, where a sharp slowdown in a whole array of economic indicators – housing finance, housing starts, consumer and business confidence, retail sales, car sales, employment, etc – indicate that the RBA is now getting the downturn that it has sought.
If history is any guide this will lead to lower inflation.
Thirdly, one of the reasons inflation became so entrenched in the 1970s was that higher fuel and food costs fed into wages growth, creating a wage price spiral.
Today there is no evidence of this. Wage growth in most countries has remained pretty benign.
With economic growth slowing it’s hard to see wages growth picking up. This is certainly the case in Australia where the softening labour market means that the risk of a wages breakout is rapidly receding.
Fourthly
