Inflation is back

The shade of Paul Volcker — the former chairman of the US Federal Reserve who died in December 2019 — is getting restless.

Volcker pushed up the US Federal Funds rate to an astonishing 20% in March 1980 and kept it above 16% until May 1981. The Federal Funds rate is the interest rate banks pay for overnight borrowing; the rate which affects the Dollar’s value and other business assets; and the rate that sets the mark for interest rates around the world.

The so-called ‘Volcker Shock’ was delivered to combat inflation which in the US had risen to an annual 10%. Volcker stifled inflation — but helped create the 1981 recession, and triggered the Latin American debt crisis. That came to a head in 1982, when Mexico said it was no longer able to service its debt. Prior to Volcker, US policymakers thought that higher inflation would help lower unemployment. They preferred to let the economy ‘run hot’ and ignored the threat of inflation getting out of control — which it did. Are their successors making the same mistake today?

The headline US inflation rate is now an annualised 5%, up from 4.2% last month. This is close to its last peak of 5.6% in 2008, when crude oil prices rose above $140/barrel and US nationwide gasoline averaged more than $4/gallon. The consumer price index (CPI) — the underlying measure of inflation which excludes volatile items such as food and energy — rose by an annualised 3.8% in May, the most since 1992, after a 3% rise in April. The cost of transporting a forty-foot cargo container from Shanghai to the US is now 547% higher than the seasonal average over the last five years. Wholesale price inflation in the world’s workshop, China, jumped by 9% in May, the fastest pace in more than 12 years. It stretches credibility that these rises will not feed through to the average consumer.

Yet Jerome Powell, current chairman of the US Federal Reserve and the US Treasury Secretary, Janet Yellen, are taking a relaxed ‘wait and see’ attitude to rising inflation. They are understandably anxious not to snuff out the nascent post-COVID economic recovery, which could happen if they pushed interest rates higher. Let’s not forget the Fed’s dual mandate — maximum sustainable employment and price stability. They take comfort from the fact that about half of the rise in the latest consumer price index came from components associated with the re-opening of the economy, such as used cars, lodging, airfares and dining out. They do not regard the inflation spike as ‘sticky’ but transitory.

Some components of the CPI rose significantly — single family existing home prices showed a year-on-year increase of 18%. This may well be due to yield-hungry institutional investors bidding up home prices and accumulating property portfolios. According to JD Power, the global data company that tracks the US vehicle market, the average new car price in May was 12% higher year-on-year; retail prices for used cars have gone up by 20% since the start of the year.

Once they have gone up, prices — for everything — tend not to come down. So even if inflation is not overall ‘sticky’, and its rate comes down over the next few months as more workers return and productivity improves, individual prices may prove very ‘sticky’ indeed.

The economic recovery from the pandemic is among “the strongest recoveries from recession since 1945”. But it is an odd recovery. Developed economies are doing well, thanks to loose money splashed by governments who have taken on more debt; the additional money supply amounts to an average of 15% of gross domestic product in high income countries but just 3% in emerging and developing countries.

The tiger never dies

Andy Haldane, the chief economist at the Bank of England (BoE) has said the UK risks a wage-price spiral similar to that of the 1970s and 1980s. “The inflation tiger is never dead” he said. Britain’s consumer price index more than doubled to 1.5% in the 12 months to April and the BoE expects it will overtake its 2% target later this year. “The risks at the moment for me are that we might overshoot that number for a bit longer than we’ve currently planned”, added Haldane.

The BoE governor, Andrew Bailey, on the other hand, evidently shares the relaxed Powell/Yellen view. UK and US central bank officials regard the inflation spikes as ‘transitory’.

Americans are not the only ones facing a sudden spike in prices. Russia’s consumer price inflation went up by 6% on an annualised basis last month. Not for Elvira Nabiullina, governor of Russia’s central bank, the ‘wait and see’ stance of Powell and Yellen. The Russian central bank has a target of 4% inflation. Nabiullina and her board pushed up the reference interest rate by 50 basis points, to 5.5%. President Putin is more alarmed than his US counterpart by soaring prices for basic foodstuffs; the UN Food and Agriculture Organization said at the start of June that its index of food prices was 40% higher year-on-year in May. In Lebanon, Syria and Sudan food price inflation is more than 200%, according to UN World Food Programme. Nestlé and Coca-Cola have said they would pass on any increases in basic commodities to retail customers.

The end of deflation

We have become adjusted to things getting progressively cheaper, particularly in tech goods and services. This benign period, known by some as ‘The Great Moderation’, a ‘goldilocks’ period of a multi-decade period of low inflation combined with positive economic growth, which lasted roughly from the mid-1980s to 2007, is ending.

What might this mean for gold? Since President Nixon finally cut the cord linking the US Dollar to gold on 15 August 1971 the average annual growth rate of the gold price in US Dollars has been 10.16%, while the annualised economic growth rate has been 7.91%. The past is no certain guide to the future — but it may contain signposts. According to one of the most thorough analyses of the monetary landscape published this year, “we are likely moving into a period of inflation caused by strongly rising money supply growth… the conservative baseline scenario has resulted in a price target of $4,800 for gold at the end of the decade”.

We are just a short step away from a repetition of the pre-Volcker period, in which a crushing level of international indebtedness — which reached $289 trillion US Dollars in the first quarter of 2021 according to the Institute of International Finance, 12% higher than the end of 2019 and a global debt-to GDP ratio of more than 355% — threatens to de-stabilise the global financial system. Powell and Yellen may say they are content to wait until 2023 to start raising interest rates; but meanwhile the tiger is flexing its claws.

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