EPaper

How high will inflation rear its ugly head?

● Rabali is chief investment officer at Lima Mbeu Investment Managers.

The global economy is gradually reopening, while monetary and fiscal policies continue to support the economic recovery.

Pent-up demand has been unleashed, leading to higher inflation. The World Bank expects global inflation to continue rising for the remainder of this year and to remain within the target bands in most inflation-targeting countries.

But the rapid rise in commodity prices over the past 12 months has led to investors questioning whether central banks are not being too complacent. Could we wake up in 12 months’ time to find inflation spiralling out of control?

Why is inflation significant?

Inflation is a measure of how fast the prices of goods and services are rising. Very high or very low inflation is considered bad for the economy, so most governments try to maintain inflation within a target range. Persistently high inflation erodes the incomes of the poorest households and may tip some into poverty. This is a severe risk for SA, with high unemployment rates and a large population earning a meagre income.

Food accounts for a substantial share of consumption in the inflation basket for this market segment. The recent sharp rise in food prices has led to much higher inflation and compounded the challenges confronting the poor during the pandemic.

But higher inflation does not affect the poor only. Inflation can be good for investors if their investment asset values can rise faster than the general level of inflation. However, it can be bad for investment assets where the returns tend to be fixed. As a result, portfolios with high levels of cash and fixed-income instruments are particularly vulnerable to rising inflation.

Are we heading for an inflation crisis?

Yes, we are, according to Nouriel Roubini, the “Dr Doom” economist who predicted the 2007/2008 financial crisis. His view is that today’s highly loose monetary and fiscal policies could result in stagflation when combined with several negative supply shocks. Stagflation is an economic environment characterised by high inflation alongside an economic recession.

To see how undesirable stagflation is, we need to look at the example of the US in the 1970s, where inflation seemed to feed on itself.

People began to expect continued increases in the price of goods, so they bought more. This increased demand pushed up prices, leading to demands for higher wages, which pushed prices higher in a continuing upward spiral.

This led to greater government borrowing, which pushed up interest rates and increased costs for businesses and consumers even further. With energy costs and interest rates high, business investment fell, and unemployment rose to uncomfortable levels.

Therefore, stagflation would be catastrophic, particularly for emerging-market countries like SA. Record-high government debt levels burden such countries. Also, their economic growth recovery is lagging behind that of developed markets due to the uneven distribution of vaccines.

There are valid reasons investors should be worried about inflation spiralling out of control in the long run. Three factors that have contributed significantly to falling inflation over the past 50 years are beginning to fade.

First, global value chains have contributed to lower inflation through greater competition. But an increase in trade tensions over the past few years and the more recent scramble for Covid-19 vaccines has raised the agenda of countries reshoring for strategic reasons. Reshoring is the relocation of production facilities within one’s own country.

Second, many countries have put in place unprecedented fiscal support programmes in response to the Covid-19induced recession. It can be argued that the asset purchasing actions of central banks have served to fuel financial markets, with very little of that money filtering into the real economy.

In contrast, government support programmes worldwide have effectively dished out cash to the man on the street to buffer demand. If these unprecedented policy measures are not unwound soon, inflation could eventually spiral out of control.

Third, despite the objections from central banks, we cannot overlook that asset purchasing programmes may make them less independent. They are exposed to political pressure to reduce the government interest burden. Most central banks view the current rise in inflation as transitory, but can they afford to take a different view?

Higher interest rates will erode the capacity of governments to spend on growth initiatives or social spending programmes. Not an ideal situation for an economy trying to avoid a double-dip recession.

So, are we heading for an inflation crisis?

For now, long-term expectations point to continued low and stable inflation. In SA, the inflation break-even rate, which measures what the market expects inflation to be in the long run, points to inflation remaining within the Reserve Bank’s target range.

However, the market is not always correct. Many investors know only one interest rate environment — falling nominal rates and rising bond prices. This might be the right time to start considering appropriate investment strategies if the converse became true.

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2021-07-30T07:00:00.0000000Z

2021-07-30T07:00:00.0000000Z

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