That villain, inflation – 7 October 2021

The Concise Oxford English Dictionary tells us that inflation, in economics, “is a general increase in prices and a fall in the purchasing value of money”. Inflation is measured by calculating the price increase of a basket of goods and services on an annual basis, and reflects general price increases over a year.

By extension, inflation also refers to the general increase in the cost of living – for example, the prices of groceries, transport and rent. Most people understand the challenge of meeting regularly increasing cost of living expenses for groceries, transport and rent without similar increases in their income. Inflation erodes the value of money and reduces the spending power of consumers.

Inflation has an adverse effect on the financial position of salary earners, as salary increases are often lower than the rate at which prices increase. However, while destructive for salary earners, it has an absolutely savage impact on the vulnerable who either live on a fixed income (e.g. pensioners) or depend on social support (e.g. the poor).

Many years of experience have taught us that one of the ways to reduce high inflation is through high interest rates. Higher interest rates generally reduce consumption expenditure, cool economic expansion and result in lower inflation.

Direct control measures such as price controls and high product taxes are not effective, as they create an unregulated black market that deprives Government of legitimate taxes and often results in higher prices. A good example of direct control measures failing is the thriving and very expensive black market in tobacco products that came into existence in 2020 when Government prohibited the sale of tobacco products during the initial Covid-19 lockdown period. Direct control measures are often circumvented by a parallel US dollar price structure for goods and services, as has happened in Zimbabwe.

To control inflation, central banks use an inflation targeting approach to create stability in an economy. In South Africa, the Reserve Bank has long maintained an inflation target of between 3% and 6% p.a. Similarly, the US has maintained an inflation target of 2% p.a. for an extensive period. Should actual inflation exceed the inflation target, the expectation is that central banks will take appropriate action to reduce inflation by, for example, hiking interest rates). In 2021, there have been concerns about US inflation exceeding 5% p.a., which would result in the US Federal Reserve (Fed) hiking interest rates. However, Fed chairman Jerome Powell has made it clear that the high level of inflation is expected to be transitory or temporary and that the Fed would not resort to hiking interest rates unexpectedly.

Inflation – Source: IRESS

There are those who question whether the Fed is not perhaps running the risk of getting it wrong by allowing the US economy to overheat with inflation well above 2% p.a. until full employment has been reached. US unemployment is currently 5.2%, which is close to the natural full employment number in the US. Is there a risk that the Fed is pushing too hard to reach full employment, getting the timing wrong as in the 1970s?

In South Africa, inflation has been reduced to a manageable single-digit level since the 1990s. Inflation peaked at 20.7% in 1987. During the 1990s, and because of the political independence of the South African Reserve Bank, interest rates were maintained at sufficiently high levels to break the cycle of excessive inflation expectations. This followed a similar experience in the United States two decades earlier, when Fed chairman Paul Volcker pushed interest rates to as high as 19% to bring down inflation from a peak of 14.73% at the time.

What causes inflation? There are three types of inflation, namely demand-pull inflation, cost-push inflation and structural inflation.

• Demand-pull inflation is most easily observed when demand for goods and services outstrips supply. An example of demand-pull inflation is when meat or vegetable prices increase due to a drought or when Apple releases a new iPhone. Critically, demand-pull inflation reflects the dynamics between supply and demand for goods and services.
• Cost-push inflation is observed when the input cost to provide goods or services increases. An example of cost-push inflation is the effect of the rising petrol price on the prices of goods and services, e.g. the price of bread.
• Structural inflation occurs when administered prices, such as the price of electricity, increase. The price of electricity does not reflect supply and demand dynamics and is not explained only by input costs. Consumers also do not have the choice not to consume electricity, to purchase electricity from a different source or to switch to a viable alternative product.

Since the Global Financial Crisis in 2008 and the coronavirus pandemic in 2020, an important factor that now contributes to inflation is the increased money supply created by central banks. For example, before the Global Financial Crisis in 2008, the credit extended by the Fed totalled approximately US$875 billion; one year later it amounted to US$2.25 trillion. Before Covid, the credit extended by the Fed was approximately US$4.00 trillion (December 2019), and one year later it was US$7.35 trillion. By creating extra dollars without the US economy growing in equal measure, the exchange rate of the dollar is expected to come under pressure. More dollars in circulation results in both price and asset inflation and creates the possibility of an overheating economy.

The type of inflation most often experienced in large, open economies is demand-pull inflation, as prices increase purely as a result of higher demand for goods and services than the economy’s ability to supply these goods and services. A clear sign of demand-pull inflation is near full capacity utilisation of production facilities in economies.

South African inflation is more often cost-push inflation and structural inflation, demonstrated by general price increases in goods because of higher petrol prices, and general price increases because of higher electricity prices.

Why is inflation topical now? There are three reasons:

1. The very high level of credit extended by the Fed (US$8.34 trillion as at September 2021).

If left unchecked, the increased money supply is expected to drive up consumer and price inflation. However, the Fed recently announced that the increased money supply will be tapered from November 2021 onwards. We expect the Fed to approach the tapering responsibly (tapering refers to reduction in credit extended or reduction in money supply).

US Federal Reserve Credit extended – Source: IRESS

2. Energy prices (e.g. oil, coal, natural gas) have risen sharply since 2020.

Prices have increased by multiples since 2020. The global economic recovery drove up energy prices, but there is a shortage of carbon fuel supplies, as much less resources have been developed recently owing to the large-scale conversion to renewable energy resources. To date, some renewable energy resources have proven less reliable than expected. Higher energy prices are passed on to households.

Energy prices – Source: IRESS

Date	Oil Brent spot USD per barrel	Coal USD per metric ton	Natural gas future (index points)
2018-12	54.44	101.12	2.94
2019-03	67.59	84.63	2.662
2019-06	64.41	68.83	2.308
2019-09	60.78	71.68	2.402
2019-12	66.15	69.08	2.183
2020-03	26.35	67.38	1.64
2020-06	41.27	53.4	1.751
2020-09	42.3	61.1	2.527
2020-12	51.8	82	2.539
2021-03	62.74	91.35	2.608
2021-06	74.62	125.25	3.65
2021-09	78.31	212.00	5.867

3. Food prices are increasing around the world.

Again, this cannot be attributed to the global economic recovery only. The prices of food oils, cereals, sugar, dairy and meat have all increased to levels higher than before Covid.

FAO Monthly Food Price Index (2014-2016=100) – Source: www.fao.org/worldfoodsituation/foodpricesindex/en/

Date	Food Price Index	Meat	Dairy	Cereals	Oils	Sugar
2018-12	92.2	92.9	97.8	100.9	76.9	78.3
2019-03	93.1	94.6	105.6	97.4	78.5	78.7
2019-06	95.3	101.2	102.9	98.7	77.5	79.9
2019-09	93.3	101.0	99.6	91.6	83.9	73.5
2019-12	101.0	106.6	103.5	97.2	101.5	83.0
2020-03	95.1	99.4	101.5	97.7	85.5	73.9
2020-06	93.1	94.8	98.3	96.7	86.6	74.9
2020-09	97.9	91.5	102.3	104.0	104.6	79.0
2020-12	108.5	94.8	109.2	115.9	131.1	87.1
2021-03	119.1	100.8	117.5	123.6	159.2	96.2
2021-06	125.0	110.7	119.9	129.4	157.5	107.7
2021-09	130.0	115.5	117.9	132.5	168.6	121.2

Energy and food are major expense items in any inflation basket. Higher energy prices in particular are expected to have a more significant impact on inflation, as it affects not only direct household consumption, but also the cost of production of most household goods.

Based on the increases in food and energy prices on top of high money supply, many observers are concerned about the possibility of higher global inflation in the years to follow. If higher inflation manifests, the question is whether it will be followed by interest rate hikes. If so:

• bond yields may rise, leading to lower portfolio allocations to bonds overall (resulting in capital losses to existing nominal bond positions);
• bond allocations may be switched from nominal bonds to inflation-linked bonds;
• share prices generally may come under pressure, as the discount rate used in valuation models is set to rise;
• allocations to shares of corporates that maintain high levels of debt (cost of capital increases) may be reduced;
• allocations to shares of corporates that can pass on cost increases to consumers may be maintained or increased; and
• ultimately, increased allocations to “hard” assets such as property and gold may be required to protect investors.

It is not clear whether the higher inflation currently experienced in the US is as transient as many (including the Fed) believe. What is clear is that the prices of food and energy have risen sharply, and in the past, such price rises were inflationary.

Our expectation is that South Africa may not experience the same levels of inflationary pressures as the US and Europe, but that domestic inflation could remain between 4.5% and 5% p.a. in the near term.

Despite the more nuanced inflationary pressures expected in South Africa, our financial markets are expected to follow global trends, nevertheless.

We believe it is appropriate for retirement funds and investment managers to review their investment strategies to ensure that their investments are positioned to beat higher inflation.

Disclaimer