The source of today’s inflation

Inflation in the G7 group of countries climbed above 7 per cent year-on-year in April, a level not seen in almost four decades.  Headline rates of inflation are above central banks’ targets in virtually every major developed and emerging market economy.

The roots of the current bout of global inflation can be traced back to the start of the Covid-19 pandemic, when a large imbalance between the supply of and demand for goods emerged.  The global economy contracted sharply in the first half of 2020 as lockdowns were imposed, but what followed was an unusual recession as most households were shielded from economic pain.  Many were able to continue to work from home on full pay, while the finances of many other household were protected by government schemes, with the results that in aggregate net savings rose sharply.

With consumers flush with cash and most part of the global economy closed, notably the services sector, pent-up demand was squeezed into the goods sector.  Strains in production were exacerbated by Covid lockdowns and disruption to shipping channels.  Shortages of goods caused supplier delivery times to deteriorate and the imbalance between supply and demand fed through to higher prices.

More recently, the spill-over from the tragic events in Ukraine have exacerbated those underlying inflation trends as commodity prices have soared.  That has poured fuel on the fire and lifted inflation yet further.  The peak in inflation is probably not far away but concerns remain that it will only start to decline relatively slowly for various reasons.  

First, the continued zero-Covid policy in China means that supply chain bottlenecks are likely  to persist for some time.  The imposition of lockdowns hit China’s economy hard over the past few months and is likely to ensure that economic output will contract in the second quarter compared to the previous quarter.

While the lockdowns have hit the domestic economy hard, they are likely to have far-reaching consequences for the rest of the world.  China has become central to global supply chains and the restrictions put in place to contain Covid have severely hampered manufacturing activity and caused a logjam in transport infrastructure.  For example, an aggregate of daily data on container ship congestion across 55 major ports in China has risen as vessels have been forced to wait to be loaded and unloaded.  This has historically been a sign that supplier delivery times will lengthen and there is a risk that supply chains will deteriorate markedly again.

A second reason for the record inflation numbers are undoubtedly due to higher commodity prices.  Energy prices have somewhat stabilised since the initial shock to markets that followed the invasion of Ukraine by Russia, but nonetheless, they remain high and could go higher again.  In the meantime, Russia has cut off the supply of gas to Poland and Bulgaria and reduced supplies to other European countries.  At the same time, the EU has reached an agreement on a new round of sanctions that include an almost complete embargo on Russian energy, as soon as the end of 2022.

However, it is perhaps food prices that are the greatest thread.  According to the UN’s FAO index, food prices have already climbed by about 20% so far this year in nominal US dollar terms.  And the huge price shock in the fertiliser market means there is a risk that higher food costs will persist.  After all, Russia and Ukraine have historically been important sources of fertiliser for the global economy.   The long production cycle in agriculture means that these higher input costs could keep prices elevated for some time.  This is a particular thread to emerging markets, where food accounts for a relatively large proportion of CPI baskets.

A third concern for the inflation outlook comes from the services sector.  This is an area that is only just revving up as fading concerns about Covid have seen demand start to rebalance back from the consumption of manufactured goods.  Incoming date from the UK, which was the first major economy to abandon Covid restrictions, have shown a clear shift in demand back towards services.  

A resurgence in service sector demand is likely to require more workers at a time when unemployment is already very low and wages are rising.  Service sector activity tends to be labour intensive and therefore output prices are particularly sensitive to wage costs.  This raises the risk that services could soon take over as the key driver of inflation to add to fears of a wage-price spiral.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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