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At a turning point


The novel coronavirus outbreak has not only brought about tragic consequences for public health and severely disrupted global supply chains, it has also had repercussions for the longer-term trajectory of the global economy. The monetary and fiscal policy responses triggered by the pandemic may become the inflection points for major shifts in the global economic environment and financial markets.

A key aspect of such shifts is the rising inflationary pressure. The world has grown accustomed to a low-inflation or deflationary environment over the past two decades, but there are signs now that we may be approaching a turning point and moving into a new era of structural inflation.

From steel and copper to corn and lumber, global commodity prices have soared this year, with some key prices rising over 30 percent year-to-date. The prices of raw materials have increased, and it seems that manufacturers have no qualms about passing on the cost increase to consumers, who are willing to accept the higher prices in the loose monetary policy environment. The US Consumer Price Index this April rose 4.2 percent, higher than the consensus estimate of 3.6 percent. Excluding food and energy, core inflation rose 3.0 percent, while the consensus estimate was only 2.3 percent. The US Producer Price Index also rose in April by 6.2 percent year-on-year.

The direct cause of the present inflation is the imbalance between the recovery in demand and supply chain disruptions. Despite countries re-opening their economies, many sectors ranging from commodities to semiconductor chips are still facing substantial shortage and supply-side problems. The longer the emerging market economies remain bogged down by the pandemic, the longer the supply chain problems will exist, which cannot be simply resolved by accommodative monetary policies.

There are substantial disagreements on whether the present price inflation is only transitory, or if it will evolve toward more persistent structural inflation.

On the one hand, the slack in the real economy remains huge. The re-opening and recovery in the advanced economies have not been effectively translated into employment yet. According to the US Department of Labor, the April non-farm payroll gain in the United States was a disappointing 266,000 versus the 1 million medium estimate. The unemployment rate in the US actually inched up to 6.1 percent compared to the medium forecast of 5.8 percent. The situations are more severe in most developing countries where the progress of vaccination and economic recovery remain slow and uncertain.

On the other hand, there are warning signs flashing, indicating that inflationary pressures may snowball even in a lackluster growth environment. There has been a dramatic surge in liquid monetary assets held in the US economy over the past year. According to the Center for Financial Stability in New York, the money supply in the US, as measured by its monthly data of the Divisia M4, has grown alarmingly by over 22 percent year-on-year since April 2020. Such continued rapid growth in money supply will likely generate sustained inflationary consequences.

Moreover, the long-term trends in the real economy are also shifting toward structural inflation. As the UK economist Charles Goodhart pointed out, the demographic and globalization factors that have helped to mitigate and absorb the inflationary consequences of loose monetary policies in advanced economies over the past two decades are now reversing. Given the aging population and increasing trade protectionism, it will be increasingly difficult for the global economy to resist wage-price spirals in the coming decades.

Policymakers may have underestimated the risks of structural inflation, but more importantly, there is limited policy space for advanced economies to exit from their unconventional monetary policies. Given their massive debt burdens, it's not clear how the central banks in advanced economies can simultaneously address the risks of inflation while keeping the interest costs low so governments can service their debts.

US President Joe Biden recently announced a $6 trillion spending plan over the next decade to boost funding for infrastructure, healthcare and education. The plan is ambitious and positive for the US economy, but it will further increase the US public debt burden. The US budget deficit is projected to hit $3.67 trillion in the 2021 fiscal year. The ratio of public debt to GDP in the US is projected to reach 111.8 percent by 2022 fiscal year, and 117 percent by 2031. It will be challenging for the Federal Reserve to normalize monetary policy and interest rates in such a fiscal context.

The inflationary future will likely arrive faster and stay longer than policymakers are prepared for. It will have profound impacts on global financial markets. The rising inflation expectations and interest rate risks are over-shadowing market exuberance like a pack of hungry wolves. The longer the Federal Reserve remains dovish, the more vulnerable the capital markets will be to inflation fears. Even if the Federal Reserve stays the course with its ultra-accommodative policy stance, the market may not be as patient and volatility may return to exert some discipline.

If the Federal Reserve's loose monetary policies were to reverse course eventually, all asset class valuations would have to be recalibrated. The emerging market currencies and asset classes would likely take the brunt of the adjustment, posing challenges to policymakers and investors in the developing world. While the rainy days are not imminent, it's not a bad idea to have risk management strategies in place and start preparing for them now.

Alvin Chua is a managing director and global head of Equity and Fixed Income Sales of Trading and Research at Bank of China International and an adjunct professor at Lingnan College at Sun Yat-Sen University. Li Chen is an assistant professor at the Centre for China Studies and Lau Chor Tak Institute of Global Economics and Finance at the Chinese University of Hong Kong. The author contributed this article to China Watch, a think tank powered by China Daily. The views do not necessarily reflect those of China Daily.