Inflation is hot!
Hi everyone! It has been a while since I posted. Figured that this may be a good time to cover the current market news given a lot has happened in the past few weeks. And we are still on the topic of inflation. Some might ask, what is inflation and why almost all news channel are talking about inflation. Simply put, inflation is the rate of increase in prices over a given period of time. This is what most governments as well as consumers like us are worrying about. Inflation is regarded as on of the most pervasive economic ill which affects everyone especially the lower income groups. I have written about inflation before and if you are interested, you may click here to read about it. As of today, the IMF’s latest projections for global inflation in 2022 is 7.4% and this would be the fastest rate of inflation in 25 years.
Global Context
There is a surge in inflation globally because of a robust demand recovery post-COVID which has run into supply-side frictions, and this is exacerbated by war-related disruptions recently. Even before the Russia and Ukraine crisis, inflation was already on the rise. The global economy, in aggregate, had recovered its COVID-induced losses by Q1 of last year. Inflation readings in the advanced economies began to run ahead of forecasts during the second half of last year. The post-pandemic rebound in demand, on the back of substantial fiscal and monetary policy stimulus, was stronger than expected. Currently, the key source of inflation pressures in most advanced economies is labour market tightness. There has been a marked increase in the demand for labour against a decline in labour force participation that occurred during the pandemic which has not recovered fully. As a result, wage increases exceeded productivity gains, fuelling price pressures.
Globally, the economic growth is slacking off but remains intact, at least for this year. The rise in inflation has dented business and consumer confidence but not yet to a degree that would lead to a severe downturn this year. In the US, pent-up consumption demand remains resilient on the back of strong of employment and wage growth, and strong household balance sheets offering some buffer against the squeeze on real incomes from higher prices. In Europe, while higher utility costs are exerting a significant strain on households and firms, savings accumulated over the past few years will buffer consumption. In China, growth has slowed in the face of mobility restrictions imposed in line with the zero-COVID policy, but inflation is not a problem and there is sufficient policy space to support growth. In emerging Asia, where the uptick in inflation has been more recent and less sharp, the lifting of mobility and travel restrictions is likely to spur a recovery in demand and possibly some price pressures. Demand-pull price pressures have been accentuated by a variety of supply-side disruptions, worsening inflation. Supply chain frictions began to emerge in H2 last year, even before the Russia-Ukraine conflict. Intermittent movement restrictions in various economies caused bottlenecks across production chains, for example by interrupting freight handling in major ports.
However, one of the most significant supply shocks has been the Russia-Ukraine war. Russia and Ukraine are major producers and exporters of oil and gas, and a variety of food grains and commodities. The disruption to these supplies has sparked inflationary effects across the world. The disruption of Russian oil and gas supplies to Europe is pushing up energy prices worldwide. The impact on fuel and electricity prices across the world has been almost instantaneous and the disruption of grain exports from Russia and Ukraine is having knock-on price effects across the food production chain. These two countries make up 25% of global exports of wheat and barley, and 14% of corn. These grains are used in a variety of foodstuff, whose prices have consequently been pushed up. They are also used as animal feed – which means higher prices for meat and poultry. As rice is substituted for wheat, rice prices have also begun to increase. The disruption of commodity supplies is adding to cost pressures across a range of industrial activities. The Russia-Ukraine conflict has affected the supply of palladium and neon – two elements that are crucial inputs used in semiconductor production and this has raised chip prices which is in turn feeding through into the prices of products ranging from smartphones to refrigerators to automobiles. In short, the Russia-Ukraine war has sharply worsened the outlook for global inflation. This conflict is likely to be prolonged and thereby continue to impart an upward impulse to global food, energy, and commodity price which will in turn feed into global consumer price inflation in the months ahead.
Singapore Context
Singapore is similar from the global context and not too different. As in the major economies, inflation in Singapore started edging up towards the end of last year on the back of a strong recovery in demand. The Singapore economy grew by a robust 7.6% in 2021 and the labour market returned to full employment. Core inflation edged up progressively over the course of last year, from 0.2% in Q1 to 1.7% in Q4, as spare capacity was absorbed. The growth momentum has slowed this year but the economy remains on track to come in within the lower half of the 3-5% GDP growth forecast. In H1 2022, growth has continued and broadened across sectors, coming in at 4.4% on a year-on-year basis. The economy is currently 6% above its pre-pandemic levels. The output gap is positive at 0.6% of potential GDP, meaning the economy is operating slightly above its underlying capacity. The external-oriented sectors such as manufacturing and financial services are facing some headwinds considering weaker growth prospects in the global economy, but the domestic-oriented and travel-related sectors are performing strongly, benefitting from the easing of mobility and travel restrictions here and in the region.
The labour market has tightened, and wage growth is running ahead of productivity gains. The seasonally adjusted resident unemployment rate has declined to 3.0%, the lowest rate since end-2018. Yet, total employment is still 2.5% below the pre-pandemic level – mainly because Singapore lost 15% of its non-resident workforce since December 2019. Job vacancies are at record high levels with broad based increases across sectors and the vacancy-to-unemployment ratio is at its highest level since 1998. Resident wages have risen by an average 6.2% year-on-year over the past three quarters, running slightly ahead of real productivity growth of 5.5%. The Russia-Ukraine war has exacerbated this situation. Imported inflation reflecting supply disruptions caused by the Russia-Ukraine war has significantly added to price pressures. Import prices facing Singapore have surged by 27% in May this year, compared to the same period last year. About 80% of this was contributed by higher oil and food prices. This step-up in energy and food prices has raised inflation for electricity and non-cooked food and is feeding into transportation and food services inflation. The combination of domestic and external factors has led to a significant rise in inflation in Singapore. Core inflation picked up to 3.6% year-on-year in May, from 3.3% in April and 2.5% in the first quarter of the year. CPI-All Items inflation, which includes private transport and accommodation costs, rose to 5.6% year-on-year in May.
Inflation is expected to get worse before it gets better. Core Inflation is projected to increase to a peak of 4.0-4.5% in Q3. It will then level off, and slightly ease towards the end of this year, though still around 3.5-4.0% – much higher than what Singapore has been used to. For the whole of 2022, core inflation is forecast to come in at 3.0–4.0%. As car and accommodation cost increases are likely to remain firm, CPI-All Items inflation is expected to come in at 5.0–6.0%. Inflation is expected to ease further in 2023 but will remain well above the 1.5% rate averaged since 2000. This inflation outlook is not without upside risks. The projected profile of inflation is based on two assumptions:
- Some stabilisation of global commodity prices and unwinding of global supply chain constraints; and
- A strong pick-up in inflows of non-resident workers that helps to alleviate domestic labour shortages.
If there are fresh shocks to global energy and food supplies arising from the ongoing conflict in Ukraine or a significant overheating of the domestic labour market, inflation may end up being higher and more persistent.
Taming Inflation will mean a slowdown in economic growth
The outlook for a gentle easing of inflationary pressures
globally is also premised on strong monetary policy actions by central banks. Monetary policy dampens inflation by reducing aggregate demand to be in line with aggregate supply. In most countries, this is achieved through higher interest
rates that dampen consumption and investment demand. A slowdown in economic growth is necessary to restore macroeconomic stability and balance. The central banks of the major economies have been tightening monetary policy.
- The US Federal Reserve has raised interest rates three times since March 2022
- The European Central Bank has yet to raise rates
but has indicated it will do so this month. - The Bank of England as well as the central banks of Canada, Australia and others have also been withdrawing monetary policy accommodation.
Central banks are expected to further tighten monetary policy substantially over the next 6 months with Global economic growth in 2023 is likely to be slower. Tighter financial conditions, coupled with a squeeze in real incomes as a result of rising prices, will exert a drag on growth. It is difficult to forecast the extent of the growth slowdown next year given the complex interplay of multiple factors. Hence, it may be more instructive to think of possible scenarios.
- Good Scenario: “Soft Landing” where growth slows down sufficiently to reduce inflation but the economy avoids recession.
- Given how high inflation has climbed and the degree of monetary policy tightening that may be necessary to bring inflation down, the pathway to achieve such a scenario is quite narrow. A more likely variant of a good scenario is a mild, short-lived technical recession that tames inflation and sets the stage for a sustained recovery in growth.
- Bad Scenario: “Hard Landing” where there is a deeper recession in some of the major economies even as inflation is brought down.
- Such a scenario could occur if monetary policy tightening precipitates sharp dislocations in financial markets. In many countries, financial vulnerabilities have increased due to a run-up in private sector debt during the last ten years of highly accommodative monetary policies. Overvalued assets and high debt could magnify any growth slowdown.
- Ugly Scenario: Stagflation where growth stagnates but inflation remains high.
- This could happen if fresh supply shocks or disruptions further boost inflation while monetary policy tightening sharply reduces economic activity. Stagflations are rare but when they occur, they present difficult policy dilemmas for governments and central banks
Multi-Pronged Approach to Inflation in Singapore Context
Dealing effectively with inflation requires a multi-pronged approach which includes a) monetary policy to directly dampen inflation, b) fiscal support to help vulnerable groups cope with inflation and c) sound labour market adjustments to prevent inflation becoming entrenched.
Singapore’s monetary policy is centred on managing the exchange rate of the Singapore Dollar. When inflationary pressures build up, MAS allows the trade-weighted exchange rate to appreciate faster. A stronger exchange rate helps to directly reduce imported inflation as well as restrain export demand, providing relief to labour market pressures. MAS has been proactive in tightening monetary policy in response to rising inflationary pressures, tightening policy four times in the last nine months. In October 2021, MAS slightly increased the rate of appreciation of the trade-weighted exchange rate policy band as a pre-emptive move when core inflation picked up from 0.7% in Q2 2021 to 1.1% in July-August 2021. MAS was among the earlier central banks in the world to begin normalising monetary policy. In January 2022, MAS added slightly to the rate of appreciation of the policy band in an off-cycle move to lean against gathering inflation momentum. This was before the outbreak of war between Russia and Ukraine. In April 2022, MAS re-centred upwards the exchange rate policy band and further increased its rate of appreciation. This was in view of a fresh impulse to inflation arising from shocks to global commodity prices and supply chains in the wake of the Russia-Ukraine war. And last week, in another off-cycle move, MAS again re-centred upwards the exchange rate policy band to lean against price pressures becoming more persistent. The appreciation of the exchange rate to-date has begun to restrain inflation. The trade-weighted exchange rate has appreciated by close to 4% compared with the beginning of October last year, acting as a filter against rising import prices. Domestic consumer prices have not risen by the same extent as that in the major advanced economies or global commodity prices. Year-to-date, the US and Eurozone have seen inflation rising to record highs of 8.2% and 6.8% respectively. Singapore’s headline inflation has been 5.0% year-to-date. The effects of MAS’ four monetary policy tightening moves are still working their way through the economy and will continue to dampen inflation over the next 12 months. The appreciation of the exchange rate is estimated to dampen core inflation by 0.9% points in H2 2022. Over 2022-23, the four tightening moves to-date is estimated to restrain core inflation by an average of 1.2% points each year. But monetary policy should be applied in a balanced and calibrated manner and not seek to completely offset inflation. Strengthening the exchange rate to try to fully offset the impact of global prices runs the risk of sharply curtailing growth and creating unemployment. It is important to recognise the global nature of the price pressures we are facing. When there is a pick-up in global food and energy prices of the magnitude we are seeing today, it is not possible to completely insulate the domestic economy from these increases.
Also, the government has stepped in forcefully to support vulnerable groups who are less able to bear the sharp price increases. Fiscal support has been proactive, beginning with the Budget Statement in February 2022 to the S$1.5 billion support package announced last month. Measures include cash grants and rebates on utility bills for lower-income households who have been disproportionately affected by higher prices. The government has been careful that fiscal support does not add stimulus to the economy that could exacerbate inflationary pressures. A period of inflation is not the time for expansionary fiscal injections that could add to tightness in labour, land, and product markets. Fiscal support has therefore been targeted at the more vulnerable groups and designed to avoid stoking inflation or distorting price signals. The government has given the assurance that if the inflation situation worsens significantly, it will be prepared to do more.
There is also a need for sound labour market adjustments to prevent inflation becoming entrenched which includes relieving labour market tightness through a resumption of inflows of non-resident workers and a responsible wage settlements that help to restore workers’ purchasing power without setting off a wage-price spiral. The ongoing expansion in labour supply should provide some relief to labour market tightness. The relaxation of our border restrictions and resumption of foreign worker inflows should help to moderate labour cost pressures. To prevent a further build-up in labour cost pressures, it is important that the inflow of non-resident workers continues unimpeded. The risk of a wage-price spiral is contained for now but bears watching. A concern in several advanced economies with some degree of wage indexation is that wages and prices start chasing each other and inflation gets worse and more entrenched. If real wages increase faster than real productivity, the increase in unit labour costs will lead to firms raising prices to protect their margins, setting off a second round of wage increases and a wage-price spiral. Automatic wage indexation is rare in Singapore and the pass-through from prices to wages has been historically weak. Nonetheless, the risk of a wage-price spiral cannot be discounted, especially in the context of a tight labour market and high inflation. To contain the risk of a wage-price spiral, it is important that real wage growth not exceed real productivity growth persistently and firms do not pass on in prices the full impact of wage cost increases.
There is a firm believe that inflation is hot and could stay hot. Food inflation is high and likely to go higher but easing supply-chain issues could bring it down quickly early in 2023. Core goods inflation is a similar story of potentially easing bottlenecks. Energy inflation could be volatile: Supply is exceptionally tight, but a recession could remove some demand. Inflation in core services ex-shelter is likely to remain high, as travel demand levels off but healthcare prices strengthen. I hope this is a good read for all of you and stay healthy!!
More Information
- NAHB Housing Market Index: -12 to 55 in July
- U.S. Building Permits: -0.6% month-over-month to SAAR of 1.69 million units in June
- U.S. Housing Starts: -2.0% month-over-month to SAAR of 1.56 million units in June
- U.S. Existing Home Sales: -5.4% month-over-month to SAAR of 5.12 million units in June
- Japan Central Bank Policy Meeting: The BoJ made no changes to its policy stance
- European Central Bank Policy Meeting: The ECB raised its policy rate by 0.5%
- Japan Consumer Price Index: +2.4% year-over-year in June
- Japan Manufacturing Purchasing Managers’ Index: -0.5 to 52.2 in July
- U.S. Manufacturing Purchasing Managers’ Index: -0.4 to 52.3 in July
- Eurozone Manufacturing Purchasing Managers’ Index: -2.5 to 49.6 in July
Up Next
- Tuesday, July 26:
- S&P Case-Shiller Home Price Index
- U.S. Consumer Confidence
- U.S. New Home Sales
- Wednesday, July 27:
- U.S. Durable Goods Orders
- Federal Open Market Committee Decision
- Thursday, July 28:
- U.S. 2Q 2022 GDP
- Friday, July 29:
- Eurozone 2Q 2022 GDP
- Eurozone Consumer Price Index
- U.S. Personal Income & Outlays
- Tuesday, July 26: