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Home / Business / Economy

Opinion: World on cusp of biggest inflation scare in decades

By Liam Halligan for the Telegraph
Other·
14 Jun, 2021 04:00 AM6 mins to read

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As prices increase, the dollars we earn don't go quite as far as they once did. Photo / Getty Images

As prices increase, the dollars we earn don't go quite as far as they once did. Photo / Getty Images

US inflation has jumped to its highest rate since the 2008 financial crisis. Prices across the world's biggest economy rose at an annual pace of 5pc in May – up from 4.2pc the previous month – with inflation having climbed steadily since the start of the year.

We're now on the cusp of the biggest inflation scare since the late 1970s, when the growth of the US consumer price index ballooned from around 5pc to double digits in just three years. Yet despite that, financial markets continued to rally when the May inflation data was released on Thursday, even though the figure was much higher than expected.

Why? Because traders, their pet economists and central bankers keep telling themselves and each other "it's different this time" – the most dangerous words in the English language. Much of our financial, political and media class now claim the laws of economic gravity no longer apply.

As the global economy emerges from lockdown, pent-up demand and supply chain bottlenecks are clearly creating severe price pressures. And even amid an economic bounce back, central banks are maintaining the largest monetary and fiscal stimulus programme in history.

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When news emerged that US inflation was at its highest level for 13 years, Wall Street actually rallied, the bellwether S&P 500 index of leading stocks reaching yet another new all-time high. The instant consensus was the Federal Reserve will view this inflation surge as temporary. So, no need to start reversing either ultra-low interest rates or "quantitative easing" – which, since 2008, has pumped hundreds of billions of dollars of newly created money into global markets, with the pace rapidly escalating during this pandemic.

That explains why the main US stock index is now 30pc higher than it was just before this virus emerged in early 2020 – despite the US economy having not yet fully recovered from successive Covid lockdowns. And where the Fed goes, the other main central banks – not least in the eurozone and the UK – will follow, continuing to print virtual money like billyo.

For a decade now, there has been a huge disconnect between financial markets and the real world, explained by ever more stimulus. And with central banks generating new money to buy government debt which then funds state spending, the distinction between monetary and fiscal support is seriously blurred.

The Fed added $3 trillion (£2.1 trillion) of QE to its balance sheet during 2020 – similar to its total monetary expansion throughout the decade after 2008. The Bank of England's numbers are similar in relative terms, having unleashed £425bn of pre-Covid QE up to 2019, with the total more than doubling since lockdown began last year.

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The combination of ultra-low rates and central bank largesse has seen global companies sell a record $4.4 trillion of corporate bonds in 2020. Huge state spending has also effectively been funded by an extra-large wave of QE.

While this decade-long monetary tsunami has created "feelgood" stock and bond market bubbles, QE has had very negative distributive effects – making those who already own assets much richer.

And far heavier debt burdens, accumulated over the last decade but particularly the last year, will now hobble medium-term growth – with state and corporate balance sheets much more exposed to risks of rising interest rates. And then there's the looming danger that efforts to unwind or even just slow QE could provoke yet another nasty meltdown, as bloated financial asset prices collapse.

It's now vital we avoid inflation expectations adjusting before central banks do. In other words, policymakers need to take their foot off the gas and start withdrawing ongoing stimulus, while gradually raising rates, before fears of higher inflation start impacting how businesses set prices, so becoming a self-fulfilling prophecy.

A nasty inflation spike would destroy business confidence and hammer investment, causing "stagflation" – when the economy stagnates and living standards erode, as unemployment spirals. Central banks would then be forced to raise interest rates sharply, causing enormous, very painful adjustment costs, as inflation is squeezed out of the system, as the history of the 1970s and 80s show.

It may already be too late. Bond markets are "pricing-in" inflation, despite central banks using QE to buy up big slices of government debt, effectively rigging the market. The 10-year yield on US Treasuries has risen from 0.51pc to 1.75pc over last year, although it's fallen back a little lately on further Fed intervention. The UK 10-year gilt yield has risen from 0.2pc to 0.8pc during 2021 – still low, but a huge rise in relative terms.

Because there is evidence of inflation everywhere. Oil prices have risen 80pc over the last year – as the global economy has rebooted. Food inflation is soaring, with global wholesale crop prices up an extraordinary 40pc in May, compared with the same month last year.

The price of oil surpassed US$70 per barrel last week. Photo / Getty Images
The price of oil surpassed US$70 per barrel last week. Photo / Getty Images

Drilling down into the US data, the core CPI reading – which strips out energy and food – rose 3.8pc year-on-year, the fastest rate since the early 1990s, as inflation spreads across the economy. And this inflation isn't only due to "base effects" – reflecting last May's lockdown, when demand and therefore prices were temporarily low. Month-on-month inflation has also been soaring in the US, recently at a 40-year high.

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Central banks everywhere claim inflation is "transitory" – the latest buzzword. The European Central Bank kept the stimulus taps full on last week despite significant improvement in the eurozone's growth outlook and inflation rising from 1.6pc to 2pc in May.

On top of all this, the ubiquitous "net zero" agenda is inflationary, given its impact on the cost of rare earth metals and other commodities needed to wean us off fossil fuels. Copper prices have more than doubled over the last year, for instance, given that electric cars need five times more of it than conventional vehicles. Our politicians' fixation on Elon Musk will generate long-term inflation.

Consider, also, that post-Covid QE, injected directly into the bank accounts of households and firms via government furlough and business support schemes, is far more inflationary than its pre-Covid variant, which remained largely inside the financial system, being expressed in stock and bond prices.

Our central bankers need to act like grown-ups and start speaking truth to power.

- Telegraph Media Group

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