This article first appeared in Forum, The Edge Malaysia Weekly on May 24, 2021 - May 30, 2021

The spike in inflation has spooked both the stock and bond markets. Consumer prices in the US rose 4.2% on an annual basis in April, the highest level since 2007. Central bankers immediately tried to calm the markets by saying that this spike is temporary, citing global excess capacity. So far, the markets have bought this assurance, with many analysts believing that inflation will be transitory.

There are at least four different types of inflation — consumer prices, producer prices, commodity prices and real estate prices. Central bankers monitor inflation through different indices, with the Consumer Price Index (CPI) being the commonly accepted index. The US Federal Reserve includes rent, but not real estate prices, in its price calculations.

Almost every index is showing a spike upwards, although the one that everyone watches most is inflation in the US, since any rise in the fed funds rate will have a huge impact on US bond and stock prices, not least on the US dollar exchange rate itself. The Economist’s all-dollar commodity-price index is up 90.7% as of May 11 and the Brent crude oil index is up 128.3%.

This is due to the sharp dip in commodity prices in April last year from the Covid-19 shock. In China, the Producer Price Index (PPI) spiked 6.8% year on year in April, while the CPI was more subdued at 0.6% y-o-y. This was attributed to both demand recovery and the pandemic supply shock. By and large, real estate prices have been much more resilient than expected.

The issue is not whether inflation is temporary, but whether we are in for a longer period of entrenched inflation, demanding higher interest rates. My hunch is that inflation will occur in the emerging markets faster than in the advanced markets. The reason is that the Fed will want to use inflation to erode the growing real value of US debt, so it will keep interest-rate increases lagging the inflation rate. The net consequence is a weakening US dollar.

Emerging markets like Malaysia are more vulnerable than advanced markets because our CPI includes a higher food price component. When food prices go up due to supply shocks (such as drought or excess rain) or rises in energy prices or foreign labour shortages, then the CPI will be pushed up.

Since politicians from emerging market economies (EMEs) are sensitive to higher inflation, which can lead to popular unrest and also capital outflows, the EME central banks are more likely to raise interest rates first. This has happened already in Brazil, for example. Hence, EME inflation will be gradually passed on to higher export prices. This will sooner or later push inflation in the West, forcing the rich-country central banks to raise interest rates.

Let’s review the pros and cons of what will happen next.

Those who argue for higher inflation are strict monetarists like Johns Hopkins professor Steve Hanke, who sees inflation as a monetary phenomenon. If you increase money supply without increases in productivity on the supply side, you will get inflation. Hanke and John Greenwood (the economist who suggested the Hong Kong-US dollar link) prefer currency board models, where you establish an anchor to, say, the US dollar and allow the real economy to adjust to monetary discipline, rather than tinker with discretionary monetary policy. The currency board system works to discipline fiscal irresponsibility, since the exchange rate anchor forces the government to control its own spending to defend the exchange rate.

The currency board model will not work in the US, Japan or Europe because these reserve currency countries have lost the anchor to gold. In the last 20 years, they have had very loose fiscal and monetary policies with no inflation, so they have become complacent.

The most extreme economists who are not worried about inflation are the Modern Monetary Theorists (MMT). Projecting that the future will be like the past suggests that the central bank can create money to fund fiscal spending in areas that will generate long-term productivity. If productivity rises as a whole, then inflation will not be a problem.

MMT is not mainstream yet, but its magic money formula is very attractive to left-wing Democrats, who think that you can engage in costless efforts to deal with very deep structural issues. Hence, US President Joe Biden wants to spend on both domestic welfare and long-term infrastructure. Of course, MMT critics say that if the fiscal spending is wasted, and productivity does not come back, then inflation could worsen.

Another MMT critic is former US Treasury secretary Larry Summers, who argued that secular stagnation (both stagnation in productivity and low inflation) may be the outcome. Recently, he is of the camp that Biden’s spending is overshooting in terms of fiscal stimulus.

The more convincing argument that inflation is returning structurally is presented by London School of Economics professor Charles Goodhart in his book with fund manager Manoj Pradhan, The Great Demographic Reversal (2020). They looked at evidence in the last 20 years of low inflation known as the Great Moderation, when central bankers tried to push inflation up to a target of 2% per annum through monetary easing with little success. Thus, the consensus view based on the past is that future inflation will be subdued, mainly because labour wages are flat and businesses are not investing, so growth will revert to anaemic levels.

Goodhart and Manoj contend, however, that the Moderation was due to the supply shock of China coming into global trade and production since the 1980s, keeping prices of all goods low. Global savings rose because of higher incomes (including for EME commodity producers) and supply grew also. There was no labour cost push in the rich countries, because production and manufacturing jobs were shifted overseas.

However, as the advanced countries and China age, consumption will increase, the labour force will decline and structural inflation will come back. The Great Reversal is that all the trends supporting low inflation have reversed. The counter-argument against Goodhart and Manoj is that there is so much excess capacity globally that prices will not rise.

Inflation is basically either demand pull or cost push. Given the pent-up demand and higher savings because of the lockdowns, there is a short-term combination of both interacting to push up inflation. The Biden administration understands that if wages are kept low, then inequality will rise. Hence, minimum wage levels are being raised everywhere, and the power of labour is returning. Europe and Japan have performed better than the US in terms of social stability because of better social health insurance benefits, higher minimum wages and welfare payments for the unemployed.

Consequently, to maintain higher living standards and prevent overdependence on China, the preference of US and Europe towards the onshoring of domestic production will put pressure on labour supply and push up prices.

The new Keynesian economists argue, however, that if higher labour income leads to higher productivity, then inflation will remain subdued. This was the gamble that Singapore took in raising domestic wages in the 1980s to force local industry to upgrade productivity.

Singapore moved into advanced country status in giving both higher domestic welfare in housing and provident fund benefits, as well as welcoming foreign investments and moving to higher-value services industry. Food prices remained stable, although house prices rose. This is a choice that faces Malaysia — to continue relying on cheap foreign labour, or to raise domestic wages and force industry to upgrade productivity.

With central banks now playing such an important role in financial markets, is inflation market-determined or a policy tool? If it is market-determined, you do not need quantitative easing (QE). If inflation is a policy tool, then central bankers claim that they can control inflation through either interest rates or QE.

Recent experience questions whether central bankers have that power or the tools to fine-tune inflation. Ministers of finance in charge of fiscal policy want higher inflation and negative real interest rates to erode the real value of government debt. Hence, they will put pressure on central bankers to slow down their interest rate increases. In short, central bank independence will be compromised.

If we look carefully at the long-term history of inflation in the US, inflation rose when the country was at war — during the 1861-65 Civil War, the first and second World Wars and the Vietnam War period that coincided with higher welfare spending. The late 1970s/early 1980s inflation was killed by the Volcker shock to raise interest rates sharply, which led to 40 years of a low-inflation global boom, interspersed with financial crises.

My view therefore is that global inflation is now again on the rise, and inflation expectations will be entrenched in the EMEs first, before surfacing in the advanced countries. On balance, equity markets will do better than bond markets as the latter depend too much on ultra-low interest rates. In the short run, the reserve-country central banks will continue to use QE, but their effect on growth will be negative, so central banks will have to “taper” off loose monetary policy. Monetary tightening will trigger bouts of financial crises in the face of too much debt overhang because, as Warren Buffet used to say, when the tide goes out, you know who is not wearing trousers.

Asset allocation strategies now become more important and complex than ever. Inflation, like opium, is a drug that is easy to consume, but difficult to get rid of. So is QE.

Andrew Sheng writes on global issues from an Asian perspective

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.