IS ACCELERATING INFLATION A WORRY?

[27.05.2021] As inflation accelerates in many advanced economies around the world, we look at whether it is likely to be a temporary phenomenon and the implications of this surge for the markets.

In the US April inflation rose 4.2% on an annual basis while in the UK April CPI annual inflation more than doubled from 0.7% to 1.5%. Some of this can be explained by higher energy prices and base effects (inflation was very weak this time last year as the pandemic crushed economic activity). However, some of it also reflects genuine demand and supply imbalances. On the demand side consumers have all the savings, that they accumulated involuntarily during the various lock-downs, to spend (see March 23^rd comment). On the supply side, as the economy re-opens, businesses are struggling to procure sufficient components and to hire workers. So, a burst of inflation, over the next six months seems likely while demand and supply re-equilibrate.

Whether accelerating inflation becomes a more permanent phenomenon depends largely on the ability, or otherwise, of workers to negotiate higher wages. At present job vacancies are proving difficult to fill and are now well above pre-pandemic levels. In the US this seems to relate to childcare problems, the need to care for sick relatives, more generous unemployment benefits and a residual fear of contracting Covid. So, whilst US workers currently have quite a lot of wage bargaining power this is likely to dissipate as the year progresses. The situation in the UK is slightly different as Brexit has delivered a negative labour supply shock. Around 1.3 million workers are estimated to have left the UK since late 2019 (out of a workforce of circa 30 million), while it is also much harder for workers from Europe to move to the UK to take up new jobs. So strong demand, combined with the effects of Brexit, could hand UK workers a more prolonged period of negotiating power.

Whilst the surge in inflation in the US (which is the key variable for global financial markets), is likely to prove temporary, it could still have a significant impact. Global equity markets (and in particular technology shares and growth shares) are currently very highly valued. An important factor behind this has been central bank money printing and unprecedented government support for the economy. Whilst central banks are expected to be cautious about tightening monetary policy (see May 6^th comment) a surge in inflation should prompt investors to think seriously about post pandemic market conditions. It is this that is likely to prompt profit taking and a correction in the equity markets. With too much money currently chasing too few investment ideas a market shake-out would be healthy.

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This post was written by Robin