Fasten your seatbelts, inflation is here
THE Malaysia Consumer Price Index (CPI) for March was a surprise as the headline 1.7% reading was ahead of market forecast of a 1.6% jump.
As we are now into the second quarter, it is likely that inflation reading will be elevated as Bank Negara has highlighted this fact.
According to the central bank, during this period, inflation will turn ugly mainly due to the low base effect from last year. Bank Negara also has guided that headline inflation this year would average between 2.5% and 4% but core inflation, which excluded most volatile items of fresh food and administered prices of goods and services, would remain subdued at between 0.5% and 1.5%.
Why is rate of inflation accelerating?
For example, just looking at the Brent crude oil price and retail pump prices in the second quarter of of 2020 and this year, prices of Brent crude have almost doubled while RON95 presently retails at RM2.05 per litre, although capped, is almost 50% higher than a year ago.
The transport sector has a 14.6% weight on the CPI and hence, a 50% rise in fuel prices on a year-on-year (y-o-y) basis will indeed cause inflation readings to go out of whack in the coming months.
For March 2021, the transportation segment alone saw a 9.8% y-o-y increase.
In fact, the phenomenon is not restricted to Malaysia alone, CPI is expected to rise across the world, driven not only by higher pump prices due to the low base effect, but the rise in the prices of raw materials, commodities and input.
As a result, even the Producer Price Index (PPI) has turned positive in most economies and set to rise even further in the coming months.
In the United States, the recent reading of both the CPI and PPI was at 2.6% and 4.2% y-o-y respectively. Both the CPI and PPI increases were the strongest in nine years.
Out of China, the latest CPI showed an increase of a modest 0.4% while PPI surged by 4.4% y-o-y last month, with PPI producer surging by as much as 5.8% y-o-y.
For the United States, driving the hike in the March CPI, which was above expectations, was the gasoline index, which rose by 9.1% in March and accounting to nearly half of the CPI jump in March.
Minus the energy and food, in what is referred to as core CPI, the rate of increase came in at 1.3%, a figure which was seen to be within expectations.
The Fed is watching the core Personal Consumption Expend-iture (PCE) price index.
The PCE is broad-based as it takes into account what businesses are selling, substitution effect and as well as weight effect of items in the index.
The target for the Fed is 2% for the core PCE and the last reading in February, the core PCE came in at 1.41%. Hence, if we take the core CPI in February at 1.53%, the core PCE is lower by about 12 basis points (bps).
Historically, the core PCE is always lower than the core CPI by about 30 bps. While we may see core PCE rising over the next few months, the challenge is to understand the drivers of the increase.
Is inflation demand pull or cost push?
Before answering the question as to whether the inflation data is demand pull or cost push, economists would first consider whether the data is driven by the base effect phenomenon.
We could all agree that due to the pandemic outbreak in early March 2020 and the significant knock-on impact coming from lockdowns and economic shutdowns, most economic data points were depressed either in March 2020 or the subsequent months, especially in the second quarter of 2020.
Even oil prices, at least as far as the futures market was concerned, went into negative price – something that nobody would think could ever occur.
Hence, to a large extent, the base effect is going to play havoc in a lot of economic data points, be it inflation, GDP, export numbers and retail sales. This was rather evident when China released its first quarter GDP data that showed the economy expanding by 18.3% compared with a year ago.
The inflationary pressure today could lead to a demand pull inflation on several counts.
First, especially in the United States, are the pay cheques that were dished out last month. This is fuelling demand at the consumers’ end where it is driving not only retail sales but also consumption of goods and services and large ticket items like homes and cars.
Second, although we may be in the new wave of Covid-19 pandemic globally.
In the United States, the successful inoculation programme, is causing a pent-up demand for good and services too as the general population feels that their lives are back to “normal” and are willing to spend. This demand pull inflation could cause prices to increase and thus, lead to higher inflation in the coming months.
As mentioned earlier, the increase in the PPI too is worrying and it is more so due to the rise in raw material prices, perhaps soon-to-be tighter labour market as well.
The 916,000 non-farm payrolls figure for March was mind blowing as the US economy added more jobs, especially as the economy is now on an accelerated recovery mode.
One doesn’t have to go far to see the effect of raw material prices as even the Bloomberg Commodity Index (BCI) is up almost 13% year-to-date (y-t-d). Some big moves, other than the 27% increase in oil prices, include the jump in lumber prices by more than two-thirds and most metal prices, other than gold and silver, which are higher by between 13% and 22% y-t-d.
Compare with a year ago, the price gains are even more telling with the BCI higher by close to 45%.
With higher input cost, producers would have no choice but to raise prices at the wholesale level to maintain their margins and hence the price increases will trickle down the supply chain, resulting in higher retail prices. This will inevitably will lead to higher inflation reading. Hence, globally, rates are set to increase. From the base effect inflation, to demand pull inflation and finally a cost push inflation.
For the US, headline CPI, PCE, core inflation and core PCE are set to rise to well beyond the 2% mark and it will be telling what the Fed’s response going to be when this occurs. As it is, the benchmark 10-year US treasuries were last seen at 1.56%, well below the recent high of 1.77% as markets were calmed by Fed’s comments on inflation expectations, which in their books is expected to be transitory. Nevertheless, the 10-year breakeven inflation rate remains elevated at 2.33% which basically signals markets uneasiness of inflation expectations going forward. For now, market expectations of a rate hike could occur as early as next year while the Fed itself does not see the need well into 2023 or even in 2024 for that matter. These expectations are obviously not cast in stone and based on the inflation trajectory over the next few months, the Fed or even the market, may have no choice but to bring forward rate hikes sooner than expected.
Higher rates calls for portfolio rebalancing
With rate hikes on the horizon, markets may be in for a surprise as investors would need to adjust their overall portfolio allocation under this scenario. For equity investors, rate hikes are negative market developments, more so for the tech sector and start-ups. The years of easy money may be coming to an end and it has to as we have built-up too much of asset price bubbles in the system. From current bitcoin price of US$50,000 (RM205,400) per coin to the market value of parody coin like dogecoin, which is even more than that of Maybank’s market capitalisation, to Non-Fungible Tokens (NFTs) values created out of nothing, it seems we are in big bubbles and in the world of finance, this has little sense.
For bond investors, especially for the US treasuries, the short-end of the curve has been depressed for a long time and with the anticipated rise in rates, short-term rates too will start to move up. Investors positioned on the longer duration too could be faced with uncertainty as 10-year US treasuries looks set to move above 2% mark within the next six to nine months. Hence, any rally on the 10-year US treasuries is an opportunity to take profit and reduce the duration exposure at the long end, for now. Once the rates stabilise at above 2% on the US treasuries, the duration play should be back in play as yield hunting investors are likely to bargain hunt at this level. For borrowers, with rates expected to rise from now on, they would be better off switching from floating rate to fixed rates and lock-in their cost of funds.
What about Malaysia’s OPR?
Firstly, Bank Negara has already guided that inflation is expected to rise this year and the key is the core rates that the central bank is looking at. With expectations that the core rate will remain between 0.5% to 1.5%, there is little pressure for it to raise rates this year. Nevertheless, if the demand pull and cost push inflationary pressures are consistent in the coming months, it would perhaps need to re-look at its own forecast, especially in relation to the core inflation rate. Secondly, inflation expectations or realised inflation rate will not be the sole determinant factor for Bank Negara to raise rates for now as the economy is just about the show positive data points. This trend will likely continue in the next three to six months due to the base effect impact as well as some real aggregate demand growth. All in, the Malaysia’s Overnight Policy Rate (OPR) will likely stay at 1.75% for the rest of 2021. Going into 2022, the expectations of a rate hike will likely start to build-up and hence, investors would need to start to adjust their portfolio allocation accordingly and time to fasten our seatbelts as inflation is here.