Inflation is striking back – and it will have implications for our politics

 
Paul Donovan
Oil And U.S. Gas Prices Reach All-Time High
We can't hide behind the low oil price any more (Source: Getty)

Over the last two years, thanks to a low oil price, many economies have been living under a low-inflation illusion. 2017 looks set to be the year inflation strikes back.

Rumbles of protectionism, uncertainty over Brexit, and Donald Trump’s expansionary fiscal policy all point to growing inflationary pressures further down the line. But immediate factors are already having an impact.

Crude oil generates about 5 per cent of a developed economy’s consumer price basket. In recent years, the price of crude oil fell about 75 per cent from peak to trough – obviously impacting headline inflation. The price has now stopped falling.

Read more: Saudi Arabia has surrendered control of the global oil market to US shale

Crude oil is not directly part of consumer spending – pouring a barrel of crude oil into the engine of your car will have negative consequences. However, consumers indirectly buy crude oil as petrol, airline tickets (aviation fuel) and food (diesel powered delivery trucks). The prices of gasoline, airline tickets and food are in consumer price inflation, and crude oil is embedded in these prices.

In some countries domestic labour costs are rising too, and they generate about 70 per cent of a developed economy’s consumer price basket. This is obvious for service prices; legal fees are nearly all labour costs. However, domestic labour costs also affect imported goods prices. Import prices are increased by the costs of a shop assistant, advertising executive, or truck driver – domestic labour costs.

As labour costs rise, firms either accept a lower profit margin or attempt to pass on higher labour costs to their customers by raising prices. Now that oil prices have stopped falling, labour cost pressures on inflation are more obvious.

The return of inflation is not straightforward, however. There are three complications.

1. Location location location

Domestic labour costs are created by domestic economic circumstances. Inflation is a local issue. This is why Venezuela had hyperinflation at exactly the same time as Switzerland had deflation.

Now that oil prices have stopped falling, Germany and the United States (with higher wage pressures) are likely to experience stronger inflation. Greece (with fewer wage pressures) is likely to experience subdued inflation.

2. Equities are not inflation proof

Not all companies listed on equity markets have the same pricing power. Thus, not all equities hedge inflation risks.

Most companies sell to other companies, not consumers; it is producer prices not consumer prices that matter for corporate pricing power (the retail sector is the exception). If taxes or tariffs raise consumer prices, earnings for companies that sell to other companies receive no benefit.

Inflation also varies by sector.

Read more: Spending on essentials soars as inflation starts to bite consumers

Housing, healthcare and education are 45 per cent of the US consumer price basket, but are far less important in the basket of US equities. Indeed, rising prices for housing, healthcare and education may leave consumers with less income to spend on other products.

Pricing power in healthcare could reduce spending on leisure, for example. Leisure sector stocks would not hedge healthcare inflation.

3. Who are you?

Different consumers buy different things. The spending patterns of the elderly are different to those of the young. The spending pattern of high income groups is different to that of low income groups. Generally, the inflation rates experienced by the lower income or the older consumer are above average; it is cheaper to be young and rich, if you can manage it.

Inflation inequality has political implications too.

Lower income groups “left behind” by prosperity may feel that their standard of living is not improving if inflation inequality continues. If trade protectionism disproportionately increases the prices of goods purchased by lower income groups, the subsequent inflation inequality could undermine the living standards of those who supported political populism in the first place.

Living with inflation

2017 is the year that inflation emerges from the shadow of the low oil price. It is important we all know the impact this will have on businesses, markets and consumers.

It will not be straightforward. The nuances of inflation may be its most interesting aspect as the world returns to the old normal of accelerating price increases.

In an age of political economics, leaders and policy-makers must consider how they manage their own unique brand of inflation as they attempt to deliver prosperity in an era of increasing macroeconomic uncertainty.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

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