Markets Are Ignoring the Main Driver of Today’s Inflation
(Bloomberg Opinion) -- The pandemic has prompted the fastest and most volatile economic cycle in modern times. A year ago, financial markets were in a state of panic; today there’s concern over excessive speculation. Fears of depression in 2020 have given way to alarm about hyper-inflation in 2021. Such an extraordinary macroeconomic rollercoaster defies historical comparison.
Consumer price inflation in the Group of 20 reached 3.8% in April, well ahead of central banks’ 2% reference for price stability. In the U.S. it rose 4.2% from a year earlier, the highest in 13 years and up from just 0.3% last year. These gains come on the heels of a collapse in global output a year ago.
To understand what these numbers mean, and whether alarm is warranted, it is necessary to first look into what’s pushing prices higher.
If the main driver is too little industrial capacity to meet consumer demand over the long-term, then the policy prescription would be to end stimulus measures and allow market interest rates to rise. If, on the other hand, the main driver is temporary supply shortages and recovering sentiment about global demand, then the current phase of inflation is a natural part of Covid healing.
I’d argue we’re experiencing the latter. The Covid economic cycle has been fueled by extraordinary supply-side shocks — on business investment, production chains and labor participation — as opposed to traditional demand-led forces. Hence, the correct policy answer is not to introduce doubts about the durability of the demand recovery but to instead focus on rebuilding economies’ growth potential.
This means supporting industries’ digital and green transformations with easy credit conditions (low interest rates and liquid credit markets), investment incentives and nationwide trade and supply chain infrastructure development. It also means expanding skilled workforces via training and support for equal opportunity employment. These are the levers for ensuring a sustainable pandemic recovery.
The recession a year ago coincided with uncertainty and fear of extended lockdowns. Businesses prioritized survival over growth by cancelling orders, discounting inventories and preserving cash. This led to wide-scale disruptions in investment planning and production capacity across global supply chains during the peak of last year’s economic pain.
The resulting supply issues are now coming to the fore as economies reopen. Progress with vaccinations, along with the sugar rush of fiscal aid, lockdown-accumulated savings, and equity and house price gains, is unleashing pent-up consumer demand. Spending on goods such as furniture and autos has risen to above pre-crisis levels.
Meanwhile, factories are struggling to catch up with this rapid rebound in demand. The result is a short-term surge in prices across sectors today, from semiconductors to metals to agricultural commodities.
These shortages and logistics bottlenecks are set to persist deep into 2021, as supply chain frictions take time to resolve. But it would be premature to assume that disruptive Covid uncertainty is the new normal.
Take a look at where price increases are concentrated: in sectors that were already suffering from under-investment and under-building (such as autos and housing) and in Covid-hit sectors still recovering after significant weakness (such as elective surgery and airlines). This suggests that price gains are led by short-term capacity limitations and supply frictions rather than long-term excess demand — in other words, they look less likely to last.
There are similar supply-demand imbalances in play across developed labor markets. As companies rush to reopen, difficulties with filling workplaces fast enough have pushed up wages, especially in hard-hit sectors such as retail and hospitality. Labor markets appear to be emerging from the pandemic tighter than expected, as Covid-related fiscal transfers, school closures and health risks limit many people from returning to the workforce.
But over time, especially as stimulus measures end, consumer demand will decelerate and people will go back to work. This will reduce companies’ cost of labor and lower the chance of long-term high rates of inflation. No consumer survey has linked higher inflation expectations to higher expected income growth. Recovering industrial output, delayed new investment and technological gains will further diminish higher inflation readings.
Moreover, the recent pullback in commodity prices, from copper to lumber, shows that there is a limit to how much companies can pass on higher prices to end-users, from builders to manufacturers to consumers. The effect of higher input costs has been to destroy, not inflate demand.
Still, this unique “V”-shaped economic cycle, where supply has led demand on the way down and lagged behind it on the way up, distorting price signals in both directions, carries important lessons for policy.
Expanding global potential growth, by combating the pandemic but also strengthening trade and supply-chain infrastructure, is critical for restoring full employment and price stability, and for taking economies off of Covid fiscal and monetary support. This work requires more than one-year rescue packages; it needs strategic policy commitment and regulatory transparency over consecutive political cycles.
President Joe Biden’s proposed infrastructure package and the EU Next Generation Recovery Plan are examples of such structural reforms. But swift and efficient implementation will be needed to improve economies’ sustainable, noninflationary growth.
Last year Covid forced a rethink of the role governments and central banks play in managing a wholesale collapse in global output. Now it’s forcing markets and policy makers to come to grips with the aftershocks of price volatility. If policy gets it right, then this year’s market inflation concerns will prove as transitory as last year’s depression scare. Here’s hoping.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Lena Komileva is managing partner and chief economist at G+ Economics, an international market research and economic intelligence consultancy based in London.
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