My former CBI colleague Andrew Sentence recently described central banks’ typical attitude to emerging inflation as initial denial that there is a problem, then suggesting it was ‘just a blip’, then admitting that there are inflationary pressures but that ‘they are only temporary’, before finally realising that inflation had in fact taken off, requiring urgent action to raise interest rates sharply.
The recent data suggest that, in fact, inflationary pressures in the commodity markets have scaled back a bit. The price of lumber, always one of the first to generate a supply response to high demand, since all it requires are a few extra lumberjacks, is back to $495 per thousand board feet, down from a $1,672 peak in May. Oil is down $7 a barrel from its peak about a month ago on both the West Texas Intermediate and Brent Crude measures. Even the price of food has fallen – the FAO Food Price Index edged back in June after a significant increase in May took the index to a 10-year high, up 39% on a year earlier.
My colleagues and I at Cebr have generally taken the view that the factors that determine whether inflation is temporary or not are: 1) whether the fiscal and monetary backgrounds are likely to contribute to further inflation; 2) whether economies are working close to full capacity or are growing very rapidly and 3) whether there are signs that inflation is likely to leak into the labour market. At present, these indicators suggest that the inflationary outlook in the US is worrying, while in the UK it is still possibly manageable. Meanwhile, there is much less to worry about in Asia and the eurozone.
In the US, recently released Congressional Budget Office projections show 7% GDP growth and a federal deficit of 13.4% of GDP across 2021, with CPI inflation at 5.4%. M2 has risen 38% in two years, though its pace of growth is subsiding. The unemployment rate is down to 5.4%, while the number of job openings reported by the Bureau of Labour Statistics in June was at an all-time high of 10.1 million. Some claim that the expansion of unemployment benefits has kept the labour market tight.
In the UK, too, consumer prices have risen, albeit less sharply than across the Atlantic, with inflation on the CPIH measure reaching 2.4% in June, up from 0.7% in February this year. A mixture of government stimulus, forced savings by households and loose monetary policy means that there is money sloshing around the economy and we expect inflation to hit 4.0% before the end of the year. Occasional labour shortages have been reported, though there remain a significant number of people on furlough, and much will depend on how many of those will move into new jobs once the scheme terminates at the end of September.
In the eurozone, price pressures seem more subdued, with the rate of inflation ticking down to 1.9% in June. Energy prices are the main driver of inflation, so lower oil prices and fading base effects should provide a safety buffer over the coming months. In China and Southeast Asia, producer price inflation is the bigger pressure point, with Chinese factory gate prices rising at an annual rate of around 9% between May and July this year. Consumer price inflation in China has fallen to 1% in July partly due to lower food costs.
So, whereas early in the year demand for natural resources was boosted by simultaneous recoveries around the world, it is increasingly clear that the world economy is becoming desynchronised.
We would be surprised if the US authorities do not eventually raise interest rates as well as reverse expansionary monetary action. Our forecasts also have the UK raising rates to 1% over the next two years, more than is factored in by the markets. The need to turn down the wick in the eurozone is less obvious, while in China the administrative action to curb tech companies and deal with bad debts will probably make further monetary action unnecessary.
The danger is that financial markets react with a so-called ‘flight to quality’ where emerging markets get hit badly. Traditionally, emerging market yields are highly sensitive to US monetary policy in much the same way that the UK was sensitive to Bundesbank policy when we were in the ERM (I remember explaining to a surprised Bundesbank board member while the UK was in the ERM that his actions had a proportionately bigger effect in the UK than in Germany!).
It will be hard to avoid a US economic cycle. And there will be knock-on effects in other countries. For most of the recent past, international economic inequality between countries has diminished as poorer countries have caught up with richer countries. The aftermath of Covid, with many emerging economies still struggling with the disease and lack of vaccination, and now possibly risking being caught in the backwash of a US monetary tightening, could put this into reverse.
For more information please contact:
Douglas McWilliams, Deputy Chairman Email:firstname.lastname@example.org Phone: 07710 083652