The inflation dragon awakes – but can it be coaxed back into hibernation?

Inflation dragon central banks economic activity commodity prices interest rates 2021
The dormant inflation dragon appears to have woken and is causing fear in share markets, but is it only temporary?

Inflation – it is a word that is probably fairly meaningless to a whole generation that grew up in a world where prices were fairly steady or were falling.

However, there is little doubt that the long dormant inflation dragon has now woken up and is letting the world know about it, in the form of share markets that have suddenly reversed in fear of what is to come.

In simple terms inflation is a measure of the rise in prices and there are several factors that have combined to see prices rise more sharply than for many years.

Central banks have struggled to get inflation up

For many years central banks have struggled to get inflation up to their target zone but if inflation rises too high it can have a very destructive effect on business and can cause unemployment and slow down growth.

High inflation means that businesses struggle to sell products that reflect the price they need to pay, so a builder that quotes a certain price for a renovation on the basis of current input prices could be out of pocket if those input prices rise too much during the build.

In the US, April inflation numbers rose 4.2% compared to a year earlier – the biggest rise in nearly 12 years – with food and energy big contributors compared to the depressed prices a year ago as the pandemic ripped through the world.

That was much higher than expected and has led to speculation about whether it is a temporary price spike or an indication that the inflation dragon is really aroused and will make its presence felt for a long time.

A rise in economic activity is pushing up prices

So, what are some of the factors that have pushed prices higher?

One is a general rise in economic activity, which has come roaring back after falling sharply after the virus caused from a year earlier.

That is particularly the case in the US, which has showered people with stimulus cheques and is around half way to vaccinating the entire population.

When you think about it, dropping money (in this case, an unprecedented US$6 trillion) into people’s pockets like that should have the effect of shrinking the value of money – an increasing supply of cash alone can stimulate price rises.

The rise in US economic growth has also exceeded expectations, with GDP up by an annualised 4.6% in the first three months of 2021 – a rise that is reflected in many other countries around the world as well.

A growing economy sucks in more goods and services which tend to go up in price as they become scarcer in the face of growing consumption.

That effect is boosted by big infrastructure projects, which governments all around the world have been pursuing as a way of boosting economic activity.

Faster growth increases labour costs

The rising tide of economic growth also pushes up demand for labour, which is why unemployment has been falling globally.

Another sign of that tighter jobs market is that 8.1 million jobs are open in the US but unfilled, even though a similar number of Americans are looking for work.

In simple terms, these jobs are no longer offering enough money to employ people, given the stimulus cheques have allowed workers to become pickier.

Those companies will need to increase the amount they pay people to attract workers.

Basic commodity prices: timber, copper, iron ore and steel rising fast

Another factor that is pushing up prices is steep rises in the prices of basic commodities such as iron ore, copper, timber, steel and many others.

Part of this rise is due to investors who are looking to invest in commodities but it is also demand driven.

These commodities are the raw materials that feed into many finished goods and after a time lag, increases in raw materials are usually reflected in the price of finished goods.

Chip shortage has driven up used car prices

There have also been some strange price effects caused by the pandemic.

One is a big shortage of semiconductor chips, which was caused by a range of issues including a fire in a Japanese factory, weather issues and other problems in the automotive supply chain.

This is a serious shortage given that there are up to 1400 chips in the average car – a number that will keep increasing as they become more sophisticated.

When car plants stopped production last year, chip makers diverted much of their production to consumer electronics and other areas not hit by the pandemic and it will take some time before the automotive supply chain is back up to full speed.

The chip shortage will cost the US car industry an estimated US$110 billion in lost revenue in 2021, with production being held back at US car plants despite strong demand for new cars.

It is a similar picture globally and the shortage has had the bizarre effect of greatly increasing the prices of used cars, with rises of up to 40% both here in Australia and in the US.

Those rising used car prices were one of the largest factors in the rise in US inflation as people show a preference for private transport due to COVID-19.

Only time will tell if inflation is here to stay

The big question now is, will the rise in inflation be temporary or is it a “transitory” effect, which is the line many central bankers are running.

If it is temporary rather than a longer term rise in prices, then central banks are more likely to keep their current very low interest rates intact.

However, if the inflation numbers continue to run high, then the pressure on interest rates will become irresistible and they will start to rise.

Where inflation goes, interest rates will follow

If market interest rates keep rising, eventually even patient central banks will be forced to follow suit and begin to normalise their cash rates which reached extraordinary lows to stimulate the economy.

Higher interest rates make investing in bonds and bank deposits more attractive and investing in shares less attractive as a general rule, which is why markets have been roiled by the creeping rise in global inflation.

As usual, predicting the future is a mugs game which is why market watchers are in for a nervous period of watching and waiting as they try to discern if the current inflation spike is a temporary feature or if the inflation dragon has really awoken and is set to cause a global rise in prices that could have far reaching effects.

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