Macro Insights Weekly: Inflation risk factors

Commentary: Inflation risk factors

Inflation outturn in the US gets most of the headlines, but the phenomenon goes beyond its domestic factors like strong stimulus, tight labour market, and wealth effect stemming from a frothy asset market. Many items in the consumer price index that have soared lately are taking their cues from global prices.

Given the prevalence of common factors like gas, petroleum, fertilizer, and a range of food items, inflation has picked up in the Euro Area and UK, although not as sharply as in the US. Right here in Singapore, inflation has picked up in recent months, with headline inflation running at 3.2% through October, although the year-to-date average price level is up 2% over the corresponding period last year.

China, India, and Indonesia have not yet seen comparable upward pressure to prices, reflecting subdued domestic demand and incomplete pass-through of world prices at the local pump level. Still, inflation is by no means a non-issue in India, and there is a risk of fuel prices being raised in China and Indonesia.

At the component level, energy prices have soared this year. Demand for energy has jumped due to trade rebound, with gas prices jumping on account of low stock and strong demand, especially as coal usage has been discouraged. On oil, OPEC quota has held up, Shale production in the US has been poor, and transportation demand has jumped with economic re-opening. Coal has suffered from pandemic-induced supply disruptions. In all cases though, supply is coming back.

Outside of industrial economies, food prices form a large part of the CPI and represent major political social sensitivities. Scanning the production and supply of food worldwide, there are reasons to worry.

Although two major food items, rice and soybean, appear to have moved past the pandemic-induced supply crunch and Chinese idiosyncratic factors (a major spike in soybean-based feedstock demand last year), many other staples, including cereal, coffee, sugar, meat, fish, and edible oil have undergone supply shortages while meeting with sustained global demand. With no major driver of the supply-demand dynamic to ease (production is somewhat inelastic in the short run, and climate change related events are causing crop failures with increasing frequency) in the pipeline, elevated food prices could cause considerable stress in developing societies that are food import dependent. Another risk is that the USD would strengthen further next year around taper and rate increases, which tends to push up the import cost for developing countries.

There is a good chance that energy and food prices won’t keep rising due to eventual demand adjustment. But one area where demand looks rather inelastic is base metals. Demand for various metals related to electronics manufacturing continues to soar as the world turns more digital and energy transition efforts gather momentum. Low-greenhouse-gas technologies—including renewable energy, electric vehicles, hydrogen, and carbon capture—require more metals than their fossil-fuel-based counterparts. A multi-year rally in metals looks likely, although high prices of metals such as cobalt, copper, lithium, and nickel could inadvertently cause delays in climate transition.

Finally, precious metals would be obvious candidates for a rally at this juncture, as their historical role has been to act as a hedge against a broader rise in the price level. Oddly, that has not been the case. Gold and silver both jumped during the uncertainty-heavy face of the pandemic, but since then gold has been largely flat or weak, while sliver, jumping on the back to demand from China, has corrected lately with China’s slowdown. The market appears to be still rather sanguine about the medium-term inflation scenario.