Why Inflation Won’t Go Away Soon In Just Four Words: China, Services, Oil, and Interest Rates

Inflation is becoming one of those visits that are too intense and that last longer than desired. The experts and economists who warned of this possibility during 2021 were branded as doomsayers and catastrophists, however, today it can be said that they were right and that perhaps they have even fallen short. By mid-2022, inflation has not only not gone away, but probably has not even peaked. Also, his presence could last for a while. The rise in prices has been conquering component by component of the typical consumer basket and now it seems that it is the turn of services, a branch in which prices are usually more stable and ‘sticky’.

Although some trends and indicators show some relaxation in prices, it seems that there are other opposites that may be more powerful. Jörg Krämer and Bernd Weidensteiner, economists at Commerzbank, believe they comment in the bank’s monthly newsletter that “inflation is likely both in the euro area as in the US reaches new highs in June. Core inflation should also continue to rise in the medium term, at least in the euro area. In this environment, the market is likely to revise its expectations for key Fed and ECB rates even higher.”

David Rees, senior emerging markets economist at Schroders, believes that the pervasiveness of inflation will not go away anytime soon and gives several reasons to support this hypothesis. Among these reasons, China’s problems in recovering its activity after the covid lockdowns, the growing strength of inflation in services and the foreseeable problems in the raw materials market stand out. To all of the above must be added the difficult task of the central bank to calm an inflation that largely comes from the supply side.

-China: the continuity of the covid-zero policy in China makes it likely that bottlenecks in the supply chain persist for some time. The imposition of lockdowns hit the Chinese economy hard in April and economic output (GDP) is likely to contract in the second quarter compared to the previous one.

“After all, China has become a central element of global supply chains, and the restrictions imposed to contain Covid have severely hampered manufacturing activity and caused a bottleneck in transport infrastructure. For example, A set of daily data on container ship congestion in China’s 55 major ports has increased as ships have been forced to wait to be loaded and unloaded,” says David Rees.

-Interest rates: the central bank is accelerating the pace of its tightening policies in an attempt to curb inflation. However, these measures (rate hikes and draining of liquidity) have a direct impact on demand, but do not per se the ability to solve supply problems, which today are causing much of the blame for inflation.

A rise in interest rates is not going to make container ships reach their destination sooner or cereal production resumes in Ukraine. Although it is true that the central bank can help moderate inflation (a part if it is caused by excess demand in some branches of goods), this time its effectiveness will presumably be less than on other occasions when demand was the main component of the price increase.

-Services: This is another of the factors of great concern. Inflation has already permeated services and is rising sharply. When price increases reach this sector, it can be officially said that inflation is no longer transitory. Nomura economists warn that this is going to be the third inflation shock that we are facing. First it was energy, now it’s food, and the next will be the shock to services.

“The revival of demand in the services sector will likely require more workers at a time when unemployment is already very low and wages are rising. Service sector activity tends to be labor intensive and, therefore, production prices are especially sensitive to wage costs. This raises the risk that services will soon become the main driver of inflation, adding to fears of a wage price spiral,” said David Rees.

-Raw Materials: energy prices have stabilized since the initial shock to the markets following Russia’s invasion of Ukraine. But they are still high and could rise again, Rees warns. Refineries are working at full capacity, while fuel demand will jump this summer as citizens around the world begin their vacations. This could lead to a more intense and prolonged rise in fuel prices, leading to shortages in the worst case.

However, Ress believes that “perhaps it is food prices that are the biggest threat. According to the UN FAO index, food prices have already up about 20% so far this year in nominal terms, in US dollars. And the huge price shock in the fertilizer market means there is a risk that higher food prices will persist. After all, Russia and Belarus have historically been important sources of fertilizer for the world economy. The long production cycle in agriculture means that these higher input costs could keep prices high for some time.”

With these data, the Schroders expert agrees with those of Commerzbank and points out that inflation has not yet peaked in the euro zone or in the UK. However, this economist maintains that the United Kingdom has a more acute problem, since prices will remain high for longer in the British Isles, while in the euro zone they could return to an area closer to the ECB’s target at some point. of 2023.

Taking all these risks into account, “we have revised our global inflation forecast for this year upwards, up to 6.4%, from the previous 4.8%. Although we continue to expect inflation to decline next year, it will likely do so more slowly and we have revised our forecast upwards to 3.6% in 2023 from 2.8% previously,” Rees said.

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