A painful transition

26 October 2021

By declaring inflation as transitory earlier this year, the Federal Reserve Bank (Fed) used a well-known central banking technique, Open Mouth Operations. It aims to calm the nerves of the market which is nervously speculating as to when they will start reducing the purchases of securities and bonds. It was via this mechanism that the United States (US) Federal Reserve in tandem with the Bank of Japan and the European Central Bank expanded their asset purchase programme by over $8 trillion since the Coronavirus (COVID-19) crisis hit. The aim was to ensure interest rates remained low – in the case of the developed world at near zero - and that spending and economic growth was supported.  But this massive liquidity injection requires countries to accumulate massive amounts of debt which they have to service later. Monetarists will tell you, however, that this process is also inflationary, which erodes purchasing power if not kept in check. The Federal Reserve Bank has been at great pains to re-assure market participants that the spike in consumer price inflation this year is temporary, and it would not force it to withdraw liquidity from the system more aggressively than previously planned.

Transitory Inflation

For the un-initiated, it may indeed seem bizarre that the direction of capital markets hinges on the semantics of a word: Transitory.  So, what do they actually mean by inflation being transitory? Why do we even believe central bankers whose vested interest is to re-assure us that they are on top of things? Who am I to question the 400 PHDs working at the Fed? United States inflation has climbed from 1% a year ago to peak at around 5.5% recently and European inflation which was in negative territory last year is now well over 3%. It’s a real concern but the inflation rate is expected to decline next year.

Even for us sitting at the tip of Africa, some of the underlying factors driving inflation have been apparent. Supply chains globally have been disrupted by COVID-19. Ask anyone trying to buy a new car and you will realise that there is a waiting list. For instance, VW’s global production is down 20% year-on-year while Ford is down close to 30%. Ports around the world have also remained congested, making the movement of goods difficult and freight rates have almost doubled over the past year.

Energy Transition

Another driver relates to the energy transition required in order to achieve net zero carbon emissions by 2050. This means that the world will have to wean itself off fossil fuels, which make up some 80% of the energy supply in order to reduce carbon emissions and lower global temperatures.  But the main issue we are currently facing is that after fifteen years of under investment and a growing reluctance of investors to deploy capital into fossil fuels, the oil industry, which accounts for a third of energy supply is constrained. Also, the transition to cleaner energy should be paid for by developed economies who have been responsible for the carbon emissions for decades. And there may be a more direct link to inflation with the European Union planning a carbon border tax on carbon intensive imports.

OIL BRENT CRUDE ICE $/BARREL, USA: GOVT 10 YEAR BOND 

Source: Ashburton Investments


Chinese Transition

The Chinese government has also embarked on its own transitory journey to achieve common prosperity in order to reduce income inequality by 2050. President Xi Jinping has stated that the government intends to curb illegal incomes and widen the tax net. Also, the government is curbing certain commercial activities such as banning commercial online tutoring and limiting the time that children spend playing video games. Tencent, the Naspers associate, was forced to contribute 100 billion yuan to a common prosperity fund. Recently, the government has been reluctant to rescue high end property developer Evergrande in an attempt to curb property speculation. Chinese equities have lagged global equities by some 30% year to date in rand terms because of various crackdowns and a return to greater centralised  control which has unnerved the market.

Whether its central bank gradually reducing their asset purchases, the globe moving towards a greener economy or the Chinese behemoth taking steps to reduce inequality – the road towards a better world will not always be smooth. Our small open economy which relies on commodity exports and oil imports will feel the impact of this. After enjoying the windfall of surplus tax collections in past year and local interest rates being lowered to half a century lows, the next year is likely to be less plain sailing for our economy.