Economists are warning of a likely return to inflation as supply side constraints and labour shortages bid up prices in the US.

Warning signs emerged in June when the US consumer price index (CPI) data – which measures inflation by tracking the prices of a basket of consumer goods – showed prices had lifted 5.4% on the previous year.

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The increase eclipsed the 5% figure many economists were predicting, and marked the largest lift since August 2008.

Source: The New York Times

Jerome Powell, chair of the US Federal Reserve, acknowledged the elevated inflation rate but reassured markets the central bank would not rush to raise interest rates in a bid to wrestle inflation back down.

Speaking before a US House of Representatives panel, Mr Powell said the bank’s focus remains on delivering a “broad and inclusive” recovery in the job market and he would need to see further evidence of inflationary pressures emerging before acting.

“We will not raise interest rates preemptively because we fear the possible onset of inflation. We will wait for evidence of actual inflation or other imbalances,” he said.

Some experts however have concerns over the future of the economy, while others still are more convinced inflation is here to stay.

Decision Economics’ chief global economist Allen Sinai cautioned the generous economic stimulus provided by the Biden administration may soon prove too generous.

Dr Sinai said the US economy is at risk of overheating as life returns to normal and Americans begin to spend the money they squirreled away during the height of the pandemic.

ING chief international economist James Knightley noted that although US economic activity has roared back to pre-pandemic levels faster than most other western nations’, the supply side of the economy has been “scarred”.

“Businesses have gone bust, millions of people remain out of work while lingering COVID containment measures are leading to production bottlenecks around the world,” he said.

“Supply capacity should eventually catch up, but this could take time with the risk that we see more elevated inflation readings for longer than we have experienced at any point in the past 20 years.”

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Labouring the point

The US National Federation of Independent Businesses reported job vacancies in 48% of its businesses in June this year.

It was the fourth time in as many months the data point had set a new record high, and came amid a period of disappointing non-farm payroll growth.

Mr Knightley put this weakness in the labour market down to three factors:

• Parents forced to stay home to care for children while schools remain closed
• Nervous employees choosing to stay home due to the pandemic
• Improved unemployment benefits eroding the attractiveness of low-paying jobs

This has created tightness in the labour market and forced employers to bid up wages to attract talent – driving a spike in the number of Americans quitting their job to pursue employment elsewhere.

Source: ING

Employment costs grew at the fastest rate in 15 years as a result, and are likely to continue accelerating over the next six months, dragging on the supply side of the American economy.

Higher wages can force inflation up as employers need to pass the cost of the increase onto consumers through higher prices for goods and services, in what it known as ‘wage push’ inflation.

Meanwhile housing costs – which account for one-third of the the CPI basket – are expected to keep headline inflation above 3% for the next three months as they catch-up with surging house prices.

Rising prices drive talk of commodities supercycle

Evidence of inflationary conditions can also be seen in commodities markets, where rallying prices for raw materials have generated billions for investors.

By the end of June, the Bloomberg Commodities Spot Index (which tracks prices on 22 materials) had lifted 78% from the lows it endured in March 2020 while coal prices hit 13 year highs and benchmark Brent Crude Oil climbed 45%.

Meanwhile the metals used in electric vehicles (including lithium and cobalt, among others) have seen prices quadruple between May 2020 and May 2021.

These gains have triggered talk of a new commodities supercycle in which demand badly outstrips supply and leads to elevated prices over an extended period of time – often as long as a decade.

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Investors bracing for impact

As signs of inflation become more pronounced, share markets have taken a hit, as eagle-eyed investors watch the data to see how their portfolios will be affected.

Higher inflation is typically seen as a negative for shares as it results in higher borrowing costs, higher materials and labour costs, and – crucially – lower earnings growth expectations.

The effects are particularly pronounced in growth stocks as higher inflation typically leads to higher bond yields.

During periods of low inflation, many investors are willing to gamble on growth stocks in the hopes of decent returns at some future date.

When inflation returns and bond yields improve, they can achieve similar returns by moving lower down the risk curve into fixed income investments.

As a result, growth stocks become less attractive and investors are less willing to pay higher prices for them.

Value stocks are not immune to the impact of higher inflation rates either as it reduces the purchasing power of a dollar.

Effectively, as inflation increases investors need returns to increase in order to break even in real terms.

To learn more about this opportunity, register for our live investor briefing tomorrow at 1pm. Book your spot here.

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Sources:

• Australian Bureau of Statistics: ABOUT THE CPI
• CNBC: Inflation climbs higher than expected in June as price index rises 5.4%
• CNBC: The biggest threat to Biden’s hot economy could be his own policies
• Investopedia: Wage Push Inflation
• ING: US: The Fed looks set to pivot on inflation
• New York Times: Prices pop again
• Reuters: Fed’s Powell sticks to transient inflation scenario on Capitol Hill
• Reuters: Asian shares extend losses on renewed virus scare, inflation woes
• Bloomberg: Commodity traders make billions as battery metals prices rise
• The Wall Street Journal: U.S. Median Home Price Hit New High in June
• Mining.com: EV Metal Index quadruples year-on-year as lithium, nickel prices rally
• Mining.com: Next mining supercycle will be different than any other — report
• Aljazeera: Is the world on the verge of a new commodities supercycle?
• The Times: Global stocks tumble amid Covid concerns and rising inflation rate
• BetaShares: How rising inflation affects investment markets
• The Sydney Morning Herald: Why much-hyped growth stocks are so vulnerable to inflation