Guest column – Cameron Bagrie

Turn in the inflationary worm?

By Cameron Bagrie

The world markets are rebounding and economic prospects are looking good after taking a hit last year from covid-19.

The world is reflating amid covid-19 challenges. Reflating is a fancy word for government and central bank stimulus getting the global economy moving.

Will inflation turn up too and we end up with ‘slugflation’ – sluggish growth and rising costs? If we step aside from covid-19-related risks, the path for inflation will be critical over the coming years.

The International Monetary Fund is predicting 6% growth in 2021. There is high hope for successful rollout of the covid-19 vaccines. The IMF’s projected growth figure masks disparities across sectors and regions.

China is at one end, already bigger compared to its pre-pandemic size. Significant fiscal stimulus will boost growth in the US. On the other end are service-based economies such as the UK, France and Spain, or those who export capital goods, like Japan and Germany, and will take time to recover.

Equities continued to push new highs. The Reserve Bank’s May Financial Stability Report noted equities and bonds were pricing in optimistic economic scenarios. Commodity prices, including iron ore, copper, timber, oil and dairy are showing strength. We have resurgent demand amid supply disruptions that are forcing up prices.

Interest rates around the globe remain low but have lifted off lows as economic prospects have improved, and some signs of inflation have appeared. Policy is working.

Financial markets have gone from pricing in a negative Official Cash Rate in New Zealand to a hike in the coming 18 months; more aggressive than expectations for other central banks and one reason the NZ dollar is elevated.

This is welcome, but as the Reserve Bank also notes, “the levels of many global asset prices, and the pace of their recent ascent, have called the sustainability of valuations into question.

“More broadly, asset valuations are vulnerable to a rise in discount rates reflected in long-term yields, which have already crept up but could do so more sharply if inflationary expectations rise further”.

The Reserve Bank and other central banks will not be spooked by inflation if we see some.

Producer prices are up strongly too. After years of inflation undershooting expectations, they are seeing success.

How temporary will inflation be? We will not know the answer to that for a while.

Some major themes that have contributed to low inflation remain.

Globalisation has delivered cheaper goods. Technology is lowering costs, driving competition and pricing transparency. We have shifting demographics and low inflation expectations. The global economy could slow.

There are also pressures from other areas.

The abundance of central bank driven liquidity (the money printing), recovering demand as vaccines appear and constrained global supply, is manifesting in pricing gauges and rising inflation expectations.

Compensation of employees (labour) as a share of gross domestic product has fallen across most of the OECD over a long period.

Wage growth has been suppressed. Structural factors including technological innovation, globalisation and diminished worker bargaining power have contributed.

Labour’s share of gross domestic product (the income measure) in NZ was over 50% in the 1970s and early 80s. Labour’s share of the economic pie is currently 43%.

The policy agenda is strongly focused on redistribution. Fair pay agreements, centralised wage bargaining, minimum wage rises, extra week’s sick leave and extra days holiday. The US is seeing similar pressure with the political pendulum swinging back towards workers and away from capital. Some rebalancing is overdue to restore the economic and social ledger.

Higher wages are welcome, but we need the growth agenda in tandem. It is currently manifesting in a lot of costs and potential pressure on inflation.

Globalisation is on tenterhooks, with a nationalist narrative replacing it. Global trade peaked as a share of global gross domestic product just prior to the global financial crisis. It has flatlined since. It looks set to reverse with covid-19 exposing supply chain vulnerabilities.

NZ has had an excessive reliance on migration and border closure has exposed decades of under-investment in skills and people. Pressure on pay rates is mounting.

We are entering an era of bigger government and more borrowing – another inflationary mix. The right investment could deliver strong social and economic payoffs. There is also the risk of poor outcomes, wasteful spending and inflationary decisions.

Evolving secular shifts will not unlock inflation overnight. But the combination could be powerful and sticky over time.

Lower interest rates have turbocharged asset prices over decades, with inflation dormant. Central banks could face some hard decisions down the track, particularly with some governments borrowing positions facing debt sustainability concerns. n

Economist Cameron Bagrie says some countries are already on the road to recovery from covid’s economic hit, while others will take time.