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Will the threat of Inflation for financial markets last long?

Policymakers are expected to perform a well-balanced act, just like a tight rope walker in a circus, which should not only kill the inflation in near future but also prevent the destruction in financial markets.

December 12, 2021 / 08:21 AM IST

In the current inflationary scenario, it looks apt to recollect the beautiful definition of inflation given by Economist Colbourn. He simply called it "too much money chasing too few goods". Without going into the intricacies of in which context he came out with this definition, whether monetary or short supply of goods and services, it looks apt to analyse the current threat of inflation on the back of response to COVID-19 by policymakers across the world. Around March 2020, as the entire world was caught off guard with the spreading virus, no other option was left than shutting down the world economy which has paralysed businesses and resulted in major loss of income to all segments of society.

Two major economic fallouts of this crisis, which eventually contributed to inflation, can be identified as massive amounts of money printing by central bankers and supply chain disruptions which eventually led to shortage of goods and services.

To revive the demand and place money into the hands of individuals, respective governments around the world announced massive stimulus packages which in many cases exceeded 20 percent to their respective GDP levels. Japan seems to have created the mother of all stimulus packages whose value exceeded 50 percent of its GDP. This money eventually overflowed the containers and found its way into various asset classes like equities, commodities and other alternate asset classes including real estate by chasing the yields. This inadvertently seems to have contributed to asset bubbles with consistent rise in prices as too much money is in circulation in the system as never before.

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Apart from too much liquidity in the system, supply shortage of goods and services was also responsible for pushing up the prices when COVID related restrictions were relaxed. As economies slipped into shut down mode to curtail the spread of virus, supply chains got badly impacted as there was neither fresh production nor mobility of goods and services for existing inventory. Supply chains in modern economies play a key role as major parts of the final product to be manufactured are sourced from different regions to gain economic advantages. For instance, an automobile manufacturing unit requires 100s or 1000s of parts which goes into the final product but all are not manufactured under one roof. Rather they will be sourced from different manufacturers/suppliers. Same is the case with electronic goods where high level of skills and technology matters. For instance, advanced smartphone chips are produced in Taiwan Semiconductor Manufacturing Company. Whereas fabrication of exotic sensors and components are manufactured in highly specialized facilities located in Japan, Germany and USA. So obviously during the lock down period production and mobility of goods is severely hampered. This situation should improve over a period of time as normalcy reaches in the world economy which perhaps should ideally lead to cooling down of prices but till then upward pressure on prices can continue to remain.

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But, the current inflationary scenario seems to have placed the policymakers across the world in a catch-22 situation. In case if central bankers want to make use of their quantitative techniques to reduce the supply of money in the system by rolling back some of the stimulus measures then it will invariably put upward pressure on the interest rates sooner than later which may rattle the financial markets by pricking the asset bubbles. Recently, to address this issue of inflation, the Council of Economic Advisors to the White House did a historical study and drew some interesting parallels between the current inflationary scenario with the one which started in 1946 after the second World War period.

In fact, the current COVID-19 crisis which paralysed economic activity across the world can also be rightly compared with a WORLD WAR kind of situation sans violence and destruction as COVID crisis successfully paralysed the global economy. In a period of WAR too supply chains will get destroyed by preventing fresh manufacturing and the mobility of goods and services. And when the WAR ends it will be initially followed by pent up demand or otherwise which can put upward pressure on prices due to short supply of goods demanded in the market. In the USA it was seen that in a post second world war period demand for discretionary consumption goods like refrigerators, automobiles, radios etc witnessed sudden upsurge till the situations of supply chains improved but the inflationary scenario continued for a period of two years between 1946 to 1948 and thereafter prices cooled down. But some argue that if policymakers do not act quickly then things may go out of hand as happened in the past between 1970s to 1980s as the policy response was delayed to sudden spike in crude prices which later had cascading effect.

However, the decade of the 1970s was a very turbulent one involving two oil shocks. In the early part of the 1970s it was due to the Oil Embargo in 1973 whereas the second hike was in late 1970s due to Islamic Revolution of Iran in 1979. This majorly contributed to the ugly run of inflation in that period till Paul Volcker the then Fed Chair started aggressively raising interest rates which eventually yielded positive results by cooling off the prices by paving the way for one of the memorable bull markets in the history of the United States. Hence, the delayed response from policymakers may not be good for the economies and public at large as consistent raise in prices will impose undue hardship on citizens whereas raise in rates may not go down well with financial markets as asset bubbles will burst. So, policymakers are expected to perform a well-balanced act, just like a tight rope walker in a circus, which should not only kill the inflation in near future but also prevent the destruction in financial markets.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Mazhar Mohammad is the Chief Strategist – Technical Research & Trading Advisory at Chartviewindia.in. Prior to establishing his own consultancy in 2012, Chartviewindia.in, he was associated with Institutional Research Desk of Munai based brokers with designations of AVP (Darashaw & Co.) and Head – Equity Technical Research (Portfolio Financial Services Ltd.)
first published: Dec 12, 2021 08:21 am
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