So, will inflation raise its head and lead to higher-than-expected interest rates?

Five reasons for low inflation

Firstly, unionised labour is now a fraction of what it used to be.  Large collectively negotiated annual wage increases appear to be a thing of the past.  This is turn has led to lower inflation.

Second, the world has been investing heavily in technology and in particular, automation for the last decade.  The last two years has seen an acceleration of this trend.   Automation, robotics and ‘the algorithm’ displaces labour.  This in turn hammers another nail in the inflation growth coffin.

Thirdly, globalisation.  Low inflation of recent decades was influenced by global trade, with its emphasis on cheap production in low-cost locations, such as China, India and more recently Africa.  Open trade has also led to higher rates of immigration.

Four, immigration.  There is little doubt that a high level of immigration, especially when a large proportion of the migrant influx are looking for work, limits domestic wage growth.  Conversely, we witnessed recently that fewer overseas migrants to Australia resulted in higher wage growth.

Moreover, as we reach 90% vaccination coverage and our international borders reopen, the return of immigration will reduce labour competition and the current associated wage and salary pressures.

Five, Long Covid #1.  We see a repeat of 2021, being that we remain constrained due to new Covid mutations but this time there will be little government monies to bail us out.  Peeps will spend less.  Demand pull inflation will fade and maybe quickly.

So, we could surmise from my spiel so far that inflation is likely to remain mute.

And this is positive news because if inflation remains structurally lower, interest rates should also remain low.  Interest rates are set to rise but not as much as they would need to if inflation was operationally higher.

However, Australian CPI inflation rose 3% over the past twelve months and in the US, the corresponding measure has reached 6.2%, the highest in nearly 30 years and across the Eurozone prices are rising by is 4.9% per annum, the highest rate since the start of the Euro.

Is this just temporary, an anomaly or something more long term?  This is the $64 dollar question.

So, it would be remiss of me not to outline that there is also a case as to why higher inflation may return.

Five reasons for higher inflation

One, growing debt.  Much debt has been incurred to tackle the spread of Covid and help prevent economic collapse.  Government spending is also likely to keep running above tax revenues for the foreseeable future, resulting in even higher levels of debt.  Much of this debt will have to be repaid in raising taxes and this could flow through into prices.

In addition, restarting business operations as well as meeting post-Covid occupational health and safety requirements will require new expenditure.  Many businesses will try and rise prices to recover any pandemic losses and future higher operating costs.

Two, higher costs.  Australia faces higher transportation costs due to freight capacity constraints and a shortage of mariners from developing countries where vaccination rates lag.   At home, expansive government spending, record low rates and central bank largesse have driven up housing demand resulting in a shortage of building materials, trade labour and furniture etc.  Property prices have escalated as a result, feeding into an intensifying FOMO loop.

Three, rising geopolitical tensions.  Whilst globalisation helped reduce inflation, trade barriers and sanctions plus the ongoing Sino-American wrangling is retarding cross-border commerce, access to technologies and finance and is creating shortages of critical components, such as semiconductors and raw materials.

The rise of nationalism, enhanced by the Covid pandemic, could further exacerbate this trend.

Fourthly, the inflationary effects of climate change mania and especially the poorly thought-out energy transition – with underinvestment in traditional and economically sustainable new energy infrastructure – may result in persistent high energy prices. Carbon taxes, levies on carbon-intensive products and compliance with greenhouse gas reduction targets will also add to costs.

Fifthly, long Covid #2.  Covid-19, considered temporary at present, may become perpetual. The likelihood of substantial ongoing health costs and intermittent interruptions to activity have not yet disappeared.

Just how transient these factors are is not yet fully understood.  And that is why inflation is now a risk.

Inflation it is often said to be like a genie; once out of the bottle; it is difficult to put back in.

That is why I think central banks will act sooner than later and if they do so – and with everything crossed – they might just be able to get the genie back into the bottle.

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