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14 July 2021

Inflation: What Happens Next?

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The drivers of potential inflation over the short to medium term will be multifaceted in nature, with a range of causes both from the supply and demand side. With many economies experiencing financial hardship from the COVID-19 pandemic, it came as no surprise that governments, and in particular the governments of developed nations, exercised every tool in their war chests to mitigate the effects. With prolonged low interest rates and an unprecedented economic environment entering a sharp recovery, we ask what happens next and if history can provide some clues?
 
The 1973 oil crisis began when the Organisation of Arab Petroleum Exporting Countries (OAPEC) declared an official ban on trade with nations perceived to be supporting Israel during the Yom Kippur War – including the United Kingdom, United States, Canada, Japan and the Netherlands. As a result, the price of crude oil rose roughly 400% from US$3 to US$12 per barrel by 1974. When oil prices rose, this forced many manufacturing firms to cut back on production as they could not afford the additional fuel costs. By 1975, most of the developed world experienced what we call cost-push inflation, which is the type of inflation that occurs when production costs rise and are passed on to the consumer in the form of price rises. Annual inflation peaked at just under 25% in the UK, and roughly 12% in the US.

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In 2008, the US Government raised subsidies for ethanol production, resulting in another example of cost-push inflation. Consequently, farmers focused on corn growth for ethanol production instead of food use, resulting in the price of corn surging due to a shortage, with cost increases moving on to the consumer in food prices. Cost-push inflation also takes place from several origins outside of price increases in commodities such as oil and grains. One factor which partly contributed to the severe inflation in the 1970s was the demand for higher wages in response to growing inflation. As one of the main costs facing companies, a rise in wages ultimately impacts prices as firms look to offset the higher costs. It could, therefore, be argued that when workers in the 1970s demanded higher wages, temporary cost-push inflation (the rise in oil prices) fed into permanently higher inflation.
 
As the recovery from the Coronavirus setback continues, the inflation risks run higher for four main reasons. Firstly, we see historic levels of money supply, with developed nations utilising debt like never before. The United States is currently running in excess of US$28.3tn worth of debt, with about US$3tn being added in the past year alone. The US is not alone in this, with the pandemic adding US$19.5tn to global debt. Jerome Powell, the Chairman of the Federal Reserve, refers to the stimulus as a “bridge” to get the population and economy through this tumultuous time. The issue is that nothing is free in this world, especially when it comes to money out of the government’s pocket.
 
What this excessive global stimulus has done is lined consumers’ pockets with more savings than in an average year. With many people working from home, reducing travel and work-related spending, these levels of savings are expected to drive a boost in discretionary spending, creating demand-pull inflation. Couple this with global supply chain issues brought on by the pandemic and you have a pincer movement from cost-push inflation. With the money supply increasing to unprecedented levels, the value of major currencies has fallen considerably, with the US Dollar falling 10% year-on-year. This increases the costs for domestic companies to import components, reducing profit margins, which is likely to be passed onto the consumer via higher prices on finished goods. Additionally, supply chain disruptions have eaten into the cash reserves for many companies. With companies being conscious of the high level of savings for the consumers, prices are likely to be raised further to recuperate the losses.
 
Overall, the inflationary pressures coming out of the current ‘unpredictable’ black swan event are likely to be far greater than that of the previously mentioned crises. Developed nations may suffer a multi-pronged struggle of inflation risks from cost-push and demand-pull impacts. Whether or not, as Mr Powell believes, this is “transitory” is yet to be seen.

This article was taken from issue 10, Market Insight. To sign up for our investment publications please visit www.redmayne.co.uk/publications.

Please note that investments and income arising from them can fall as well as rise in value. This communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned.
 
Inflation: What Happens Next?

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