Roy Davidson, 6 April 2021

A key theme in 2021 has been early signs of inflationary pressures, and the higher bond yields that have followed. This has led to a sharp rise in volatility and seen a shift in investor preferences across equity markets. With markets having become accustomed to benign inflation and a very accommodative monetary policy backdrop in recent years, a reversal of these trends could certainly upset the apple cart.

Monetary policy did its job in 2020

In the years since the global financial crisis, central banks the world over have demonstrated their willingness to step in and support financial markets.

There is no better example of this than last year, when the COVID-19 pandemic caused a global recession and saw economic activity stop abruptly.

Central banks, including the Reserve Bank of New Zealand (RBNZ) and the US Federal Reserve, stepped in with unprecedented levels of monetary support to shore up markets. This complemented the fiscal support we saw from governments across the world.

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These polices have all had the desired effect, with most economies avoiding the worst-case scenarios of 2020.

Money supply growth has exploded

Economics Nobel laureate, Milton Friedman, famously said that “Inflation is always and everywhere a monetary phenomenon”.

His point was that although many factors affect the rate of inflation, one of the most crucial is the money supply. More money chasing the same amount of goods or services in an economy should, theoretically, result in rising prices.

In this regard, money supply has exploded across the world as a result of the QE from central banks. However, it should be noted that these policies are nothing new. Central banks have been doing this for some time now, and we are yet to see any sustainable inflation materialise.

Money supply growth has taken off

Money supply growth has taken off

Some signs of inflation pressures

Most central banks endeavour to keep inflation at manageable levels, and many have a target of 2 per cent per annum.

Inflation has been consistently undershooting these targets for the last ten years, and we are yet to see any evidence of a sustained uplift.

However, we are seeing signs of increasing prices. In the US, the measure of prices paid by manufacturers in the latest Institute of Supply Management (ISM) survey jumped to its highest level since July 2008.

Locally, the ANZ Business Outlook survey shows expectations of cost increases are at the highest level in more than decade. A net 74 per cent of firms expect higher costs, with a net 49 per cent planning to raise their prices in response. Firms’ inflation expectations remain slightly below 2 per cent although they are still the highest in two years.

Firms expect to see higher costs

Firms expect to see higher costs

Would inflation lead to higher interest rates?

Yes and no.

We think central bank policy rates are likely to remain flat, despite these obvious signs of cost pressures and increasing inflation expectations.

The bar is high for any reversal of the prevailing loose monetary policy settings. The RBNZ has noted that one of the biggest lessons from the global financial crisis was that central banks attempted to normalise policy too early, and that it doesn’t want to repeat this mistake.

Central banks will be very reluctant to withdraw stimulus until there is clear evidence of inflation taking hold, and of it being here to stay (rather than being transitory).

In addition, most have explicitly stated they would be comfortable letting inflation run modestly higher than usual for an extended period, to offset the persistently low inflation of the last decade.

However, longer-term interest rates could continue to push higher. Rather than being solely within the power of policymakers, longer-term interest rates are generally driven by investor sentiment and financial market conditions.

At present, financial markets are focused on an improving growth backdrop and rising inflationary pressures, which is causing interest rates to respond by increasing from the extreme lows of 2020 (while remaining well below historic levels).

We expect signs of further cost pressures to emerge over the coming months, and acknowledge this is a crucial factor in determining where asset prices ultimately go in the years ahead.

Other factors could still weigh on inflation

While the unemployment levels in many economies are nowhere near as high as many feared, they remain well above pre-pandemic levels. Crucially, underemployment or underutilisation rates are much higher.

In a similar vein, the output gap, which is the difference between actual GDP and potential GDP remains negative, for New Zealand and the US.

While it has improved sharply from the middle of last year, it is not yet pointing to the level of capacity constraints that typically result in high, sustained inflationary pressures.