The global economy has not seen severe inflation in a long time in advanced economies as the long-term secular forces of technology advancement and globalization have had a disinflationary impact. However, significant countries worldwide unleashed massive fiscal and monetary stimulus to counter the slowdown caused due to the COVID pandemic.
With the economies recovering in 2021, this stimulus feeds inflation as demand has surged, with supply failing to keep up with the order. With supply chains upended during the pandemic, there have been shortages of multiple commodities and products such as semiconductors, leading to inflation to hit record highs in major economies such as the USA, UK, Germany, and China.
Negative Impact of Inflation
Inflation generally hurts lower-income citizens as they do not have enough surplus income to manage increasing costs due to higher food and energy prices. Even with wages rising in the USA, inflation has increased faster, leading to real wages falling. Inflation can lead to lower demand and reduced margins for companies due to higher input costs. This can cause many companies to witness lower profits and earnings during times of higher inflation.
Another negative impact of inflation is that central banks are forced to raise interest rates in order to cool down inflation. Higher interest rates mean a higher cost of capital, leading to lower credit offtake and a slowing of the overall economy. Interest rate-sensitive sectors such as finance and housing are affected to a higher degree than other sectors. Stocks, in general, don’t do as well during periods of higher inflation as the growth in nominal terms is not enough to offset the increase in risk premiums or discount rates of cash flows, leading to a lower valuation and lower prices.
Positive Inflationary Impacts
Developed economies had not faced high inflation since the 1970s when there was a severe oil shock. However, current inflation, which was supposed to be transitory as per the US Federal Reserve, is proving to be anything but transitory. Inflation expectations are also increasing amongst consumers, which means that you could see higher prices for longer.
While inflation has a negative effect on the overall economy, some sectors such as materials and precious metals do better during periods of inflation. Fixed income and bonds are badly affected as their cash flows remain stationary while the value of the money goes down. Bond yields increase, and bond prices decrease during inflation while commodities generally do well.
Economies that earn higher revenue from resource sectors such as Brazil, Russia, Saudi Arabia, etc., do better while large resource consumption economies worsen. Forex markets will become more volatile, with currencies moving sharply with the changing fortunes of different economies. For example, the value of the Indonesian rupiah appreciated during the third quarter of 2021 as the prices of coal increased sharply.
Inflation is good for debtors as the actual value of their debt decline with higher inflation, while it is terrible for creditors as their debt assets decline in value. Most advanced economies which have racked up severe amounts of government debt will also benefit as the value of the debt decline due to erosion in the value of money. Savers will lose as their holdings of stocks and bonds are expected to do worse during the period of inflation.