By Nicole Busuttil
Economies are bouncing back faster than predicted from the pandemic-induced crisis. Gross domestic product growth forecasts for 2021 have been revised during June: The Fed raised this to 7.4% compared to February’s 3.7%; the European Central Bank revised this to 4.6% from March’s 4.0%; and the Bank of England raised this to 7.25% from February’s 5.0%.
The rebound, though, brought about less welcoming news. The sudden unexpected growth has led to an unforeseen spurt in inflation. It was expected that since prices during the severely impacted months declined drastically, we would see “base effects” driving headline inflation up over the same months in 2021.
On the other hand, core prices, which exclude volatile energy and food prices, were expected to remain stable. However, this has not been the case. In fact, core inflation rates have risen sharply in June to 4.5% in the US and 2.3% in the UK on a year-on-year basis. In contrast, the Euro Area core inflation rate has remained fairly low at 0.9%, however the divergence in inflation data across member states has been increasing. Economists are now expecting US core inflation to remain above 2.0% and UK core inflation to fluctuate around the target for the rest of the year. Contrary to this, Euro Area core inflation is not expected to follow suit, with economists not expecting the rate to surpass 2.0% any time in the near term.
As seen in IHS Markit June PMI data for these three major economies, price pressures continued to feed into the services sector following the easing of pandemic restrictions. Furthermore, inflation is creating production supply-chain shortages, as can be seen with the global difficulty surrounding microchip supply, these creating a backlog of work in the Euro Area, the US and the UK.
The main concern on every investor’s mind is that rising inflation will trigger a sudden tapering of asset purchases by central banks, this cascading down into emerging economies, mirroring the 2013 taper tantrum following the global financial crisis.
Most investors have been betting on the same idea for a long time – for pandemic-impacted companies to come back to the economy; for pricing of commodities such as copper, lumber and iron ore to keep rising given increasing global demand; and for interest rates to rise driven by strong growth and rising inflation expectations.
However, following the recent revisions in economic forecasts, there has been a divide in investor beliefs – those who do not believe that inflation is transitory as is being reiterated by the major central banks observed in this article and so policy will not be tightened aggressively in the near term, and those who believe the economy has been overly pumped-up and inflation will migrate from goods to services causing long-term issues, hence pushing central banks to tighten policy quicker than anticipated.
Rising inflation in the US can be considered a catalyst for a weakening in emerging market currencies. As inflation progresses, the Fed will look at raising interest rates sooner, resulting in capital flowing out of emerging markets and into US markets. This will put downward pressures on emerging market currencies and will make imports more expensive, causing import inflation to rise. On average, these currencies have fallen by 1.5% since the Fed’s hawkish June meeting. This weakness is at a time when emerging economies are less healthy than the developed economies due to their lower vaccination rates.
Some central banks have already started scaling back their purchases. The Bank of England is nearing its £895 billion asset purchases target and is likely to stop quantitative easing once the target is met. Governor Bailey is considering selling assets before raising its rates. The European Central Bank is currently debating how to run its pandemic emergency purchase programme.
In comparison, in June, monetary policy committee members stated that the Fed is discussing cutting back on asset purchases, already sending markets into a mini-taper panic. Economists are expecting tapering in the US to be announced by year end. This approach may echo the 2013 tightening, causing interest rates to rise suddenly once the prior cash injection comes to a halt.
An alternative approach to this would be to slow down the pace of asset purchases until the following year and only after should the Fed look at raising short-term interest rates. Despite the Fed showing high sensitivity to its quantitative easing signalling, asset prices have continued to run-up due to beliefs that long-term interest rates will remain low.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.