Prices are busting out all over the world. Prices charged by US producers are 20% higher than they were a year before. Consumer prices were up by a mere 5% in August. That is before the recent tripling of natural gas prices.
The cause of higher prices seems clear enough. They are a response to buoyant demand stimulated by Covid-inspired extra government spending, and central bank funding of far larger fiscal deficits, which has dramatically increased the supply of money, specifically bank deposits held by households and firms.
These savings have also reduced the incentive to immediately get a job, of which there is an unusual abundance in the US as firms struggle to match surprising strength in demand with extra output and willing workers.
This mixture of strong demand with constrained supply has caused prices to rise. The effect of higher prices is also a predictable one. Higher prices reduce demand, while they serve to encourage extra output. They also act as a drain on disposable incomes and spending power. Higher prices, particularly when they respond to supply-side shocks, can therefore lead to slower growth as these higher charges work their way through the economy.
How the monetary and fiscal authorities react to this slower growth is critical for longer-term inflation trends. Should they attempt to mitigate the impact of higher prices on growth by stimulating demand for goods, services and labour, the temporary surge in inflation could well become more permanent. Firms and trade unions will then budget for expected and uncertain inflation.
Central bankers believe inflation depends on expectations, modified by the state of the economy. Independent central banks accept responsibility for the state of demand, but they hope inflation expectations are well anchored at low rates, to make their task of containing inflation easier.
To date the markets have largely believed with them that the observed rise in inflation is a temporary one. But the markets will be watching the reactions of the fiscal and monetary authorities closely for signs of policy errors that could turn a temporary supply-side shock into permanently higher inflation.
It is striking how atypical SA’s economic circumstances have been. We too will have to deal with an energy price shock that will depress demand. But demand is already highly depressed. Particularly depressed since 2016 has been demands from companies, including public corporations, for plant, equipment, workers and credit.
Households have helped a little to sustain spending. Total spending by households grew 1% in the first quarter of 2021, but only by half as much in the second quarter. Those in jobs have earned more, but many more — well over 1-million — jobs have been lost since the lockdowns. Formal employment outside agriculture is below 2009 levels.
The money supply has flatlined as nominal GDP has grown strongly. The closely watched government debt-to-GDP ratio has been further reduced by extraordinary growth in government revenues. Tax receipts have accelerated in response to the global inflation of the prices of the metals that make up the bulk of SA’s exports, so much so that the government’s total borrowing requirement in all its forms has declined from 13.5% of GDP in Q1 2020 to as little as 1.8% of GDP in Q2 2021. Fiscal austerity has been practised in Covid-ravaged SA. And monetary policy, judged by its effects on money and credit supply, has not been accommodating enough.
With potential supply exceeding realised spending, the SA output gap is likely to remain persistently wide. Inflation expectations therefore remain unaltered. The case for higher interest rates to further depress demand seems ridiculous in the circumstances. Yet the gap between short- and long-term interest rates has widened further in recent days, still implying an expected doubling of policy determined rates over the next three years.
The bond market indicates that any improvement in SA’s fiscal circumstances is sadly expected to be temporary rather than permanent. It could prove otherwise with fiscal discipline and sympathetic monetary policy.
• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.
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