Inflation is back. Low oil prices dragged down headline inflation rates in recent years, creating a low inflation illusion. 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 gasoline, airline tickets (aviation fuel) and food (diesel-powered delivery trucks). The prices of gasoline, airline tickets and food are in consumer-price inflation. Crude oil is embedded in these prices.
Crude oil generates about 5 percent of a developed economy’s consumer-price basket. In recent years the price of crude oil fell about 75 percent from peak to trough—obviously impacting headline inflation.
Domestic labor costs generate about 70 percent of a developed economy’s consumer-price basket. This is obvious for service prices; legal fees are nearly all labor costs. However, domestic labor costs also affect imported goods prices. Import prices are increased by the costs of a shop assistant, advertising executive, or truck driver—domestic labor costs.
As labor costs rise, firms either accept a lower profit margin or attempt to pass on higher labor costs to their customers by raising prices. Now that oil prices have stopped falling, labor cost pressures on inflation are more obvious. The return of inflation is not straightforward, however. There are three complications.
1. Where you are matters
Domestic labor costs are created by domestic economic circumstances. Inflation is a local issue. This is why Venezuela had hyperinflation at exactly the same time 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.
- 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. Housing, health care and education are 45 percent of the US consumer-price basket, but are far less important in the basket of US equities. Indeed, rising prices for housing, health care and education may leave consumers with less income to spend on other products. Pricing power in health care could reduce spending on leisure, for example. Leisure sector stocks would not hedge health-care inflation.
3. Who you are matters
Different consumers buy different things. The spending pattern of the elderly is different to that 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 consumers are above average; it is cheaper to be young and rich, if you can manage it.
Inflation inequality has political implications. 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. Investors, rightly, need to consider what rising inflation indices mean for their portfolios. However, inflation is not a simplistic concept. The nuances of inflation may be its most interesting aspect as the world returns to the old normal of accelerating price increases.
Paul Donovan’s latest book The Truth About Inflation was published by Routledge in April 2015. Visit www.ubs.com/pauldonovan for more research. Paul’s commentaries in the UBS series of documentaries on Nobel Laureates in economics is available at www.ubs.com/nobel
Donovan is the managing director and deputy head of global economics of Zurich-headquartered UBS. He is responsible for formulating and presenting the UBS Investment Research global economic view, drawing on the bank’s worldwide resources. Donovan took up philosophy, politics and economics at Oxford University. He holds an MSc in financial economics from the University of London. In the Philippines his column will appear exclusively once a month in the BusinessMirror.