Mea culpa. I repeatedly indicated my belief that inflation would peak in the first quarter of this year. It now looks as if I was mistaken. Underlying inflationary pressures seem stronger than I anticipated. On top of that, the sanctions and trade boycott fallout from the Ukraine war will add greatly to inflationary pressures.
Two years ago, as the pandemic initially raged, the price of a barrel of Brent crude was at an unsustainably low price of $20. Just before Russia’s invasion of Ukraine, oil had bounced back to more than $90 a barrel. Following the launch of President Putin’s “special military operation”, it rose above $130 before hovering around $100.
There have been similar sharp rises in the price of gas. Bord Gais Energy’s move to raise its gas and electricity prices by 39 per cent and 27 per cent respectively will be a hammer blow for those who live pay cheque to pay cheque. According to a 2020 report by the Organisation for Economic Co-operation and Development, almost half of Irish workers were only three pay cheques away from falling into poverty, one of the highest proportions in 41 developed countries surveyed.
While we are understandably fixated on energy price inflation, poorer parts of the world will be more focused on basic food costs. On a combined basis, Russia and Ukraine account for about 30 per cent of global wheat exports. Current hostilities put those exports in jeopardy. The market price of wheat nearly doubled in the immediate aftermath of the Russian invasion. It’s since fallen back considerably but it’s still more than one third higher than a month ago.
The last time global wheat prices surged this much, they were blamed for triggering the Arab Spring, a political revolt that began with high hopes but ended in grave disenchantment and in destruction across Syria. Might the same happen again?
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Having risen by 5.5 per cent in the 12 months to last December, the Irish consumer price index fell back to a 5 per cent rise in January before surging to 5.6 per cent last month. The recent sharp rises in Irish inflation readings have resulted from a spike in energy prices. Excluding energy, Irish inflation would have been just 3.6 per cent last month. Across the euro area, where the annual inflation rate to February was 5.8 per cent, energy prices had risen 31.7 per cent. The energy dog is wagging the inflation tail.
Other forces are at play in America, where inflation was running at an annual rate of 7.9 per cent in February, against 5.8 per cent in Europe. Core inflation, excluding energy and food, was 6.4 per cent in the US versus just 2.7 per cent in the euro area. The US-centric nature of the global inflation bounce reflects levels of fiscal and monetary stimulus to fight the recessionary effects of Covid that were far greater than anywhere else.
So what can Ireland do to combat inflation? Having given up our currency and the ability to set interest rates and monetary policy at a national level, the government has largely the same relationship towards the eurozone that Mayo county council does. Both can make decisions about their spending, tax revenues and, therefore, borrowing. But they’re each mere economic actors operating in a monetary game whose rules are set by the European Central Bank, just like our large corporates such as CRH, Ryanair and Kerry Group.
Ministers could ramp up taxes, throttle spending and force a significant budget surplus as a strategy to slow down the economy and push down inflationary pressures. But this would be the economic equivalent of the Middle Ages remedy of using bloodletting to cure medical conditions ranging from the plague to gout. Inflationary pressures would be reduced somewhat at the expense of triggering a recession. Economically, it would make little sense. Politically, it would not be feasible.
So what can central banks do to combat inflation? In essence, they can tighten monetary policy until inflation is choked out of the economy. However, nobody knows in advance how much tightening is required to bring down inflation. As a result, central banks engage in a policy of adaptation whereby they tighten policy while watching how the economy responds. The challenge is made all the greater as the impact of raising interest rates operates with a lag on the real economy. Imagine trying to direct a car if your changes to the steering wheel didn’t have a full effect until you had driven a kilometre.
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All this means that, by tightening policy, central banks run the risk of triggering an economic slowdown or, worse, a recession. The much-celebrated Paul Volcker, head of the US Federal Reserve from 1979 to 1987, successfully beat back inflation but at the cost of unleashing two recessions in the early 1980s. Defeating inflation is a bit like going out for a long run: however great you may feel afterwards, you can feel pretty rotten in the middle of it.
The hard reality is that central banks have a very poor record of achieving soft landings. They generally go too far and push the economy into recession. That was the case in 1991, when it cost George Bush Sr his re-election a year later; in 2000, as the tech bubble burst; in 2008, as our housing bubble popped and the global financial crisis was unleashed.
Yet today, as inflation readings rise ever higher, the anti-inflation credibility of central banks is being questioned. When their target rate is 2 per cent, what the heck are they doing standing still? Even before the inflationary impact of the Ukraine war, recorded inflation had already risen above 5 per cent.
The challenge facing the ECB is that raising interest rates suppresses demand but recent rapid rises in energy and food prices result from supply constraints. It must also face commodity markets brimming with speculative froth: on Monday, March 7, the price of a barrel of Brent crude rose as high as $139; on Wednesday last week it fell below $97, a drop of more than 30 per cent.
Who’d be a central banker? Damned if you do, damned if you don’t.
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PS: In theory, the London Metal Exchange (LME) offers a market clearing place where producers and consumers can enter into binding contracts with one another for the future delivery of various metals. It offers both parties greater price certainty and the liquidity of an actively traded market. But the LME thereby also offers a marketplace to those who would speculate on the prices of various metals.
Xiang Guangda, a Chinese tycoon who runs the stainless steel giant Tsingshan Holding Group, had a big bet against nickel but its price shot up after Russia invaded Ukraine. Xiang lost a lot of money. The exchange demanded Xiang’s brokers put up more money to cover his losses. In turn, they demanded more money from him, which he no longer had.
That put Tsingshan’s banks and brokers — including JPMorgan Chase, BNP Paribas and Standard Chartered — in acute difficulties. They had offset their trades with Tsingshan by buying their own short positions. Now they had to pay big margin calls to cover their losses while receiving no payment from their client.
As a result, Tsingshan and others facing the same problem had to exit their short trades, but that just pushed the price higher and led to more margin calls and, eventually, a short squeeze. Savvy traders bet on the price of nickel going up as they knew this would squeeze short sellers into becoming buyers, allowing them to profit. Having started this month trading at $25,000 per tonne, the price of nickel shot up towards $100,000.
That price would have reportedly forced into bankruptcy several brokerages that are LME members. The exchange responded by cancelling trades after Monday’s close of $48,078 per tonne. Matt Chamberlain, the LME chief executive, said cancelling trades was necessary as the size of the short position in rocketing nickel presented a systemic risk.
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Cliff Asness, of the AQR hedge funds, tweeted that the LME was protecting the prodigal to the detriment of the non-prodigal, in more colourful terms. He added: “Everyone who trades should know what you did. You got lawyers, I’m ready. Bring it slime balls.” Fun times ahead.
