Markets are worrying about rising inflation, but to date, there has been no evidence yet of ‘demand-pull’ inflation amplifying cost-push pressures, especially in Asia. There is also no sign of a global wage-price spiral. Nevertheless, we believe there are reasons to be concerned.
Producer price inflation (PPI) has been rising in China, which is a major buyer and supplier in global markets. Markets are right to worry if China is raising prices. If buyers of Chinese goods are paying higher prices, China is exporting inflation to the world.
Concern has also centred on the Biden administration’s trillion-dollar stimulus plans. Analysts had already warned that last year’s USD 2.2 trillion Coronavirus Aid, Relief and Economic Security Act would massively increase money supply and could set off hyperinflation.
However, while the period after the Great Financial Crisis saw anxieties about the possibly inflationary effects of the many billion-dollar rounds of quantitative easing (QE), we note that 13 years after the GFC, there is still no sign of inflation.
Who killed the Phillips curve?
This curve charts the relationship between inflation and unemployment (and by extension output growth). It states that the inflation rate rises as the unemployment rate falls.
By conventional Phillips-curve logic, the massive US stimulus programmes could be expected to drive down unemployment and push up inflation. However, the curve has had a rough ride since 1969. In the 25 years since then, the dominant economic thinking has been that any attempt to reduce unemployment below the full employment ‘natural rate’ would only produce hyperinflation.
Intriguingly, since the mid-1990s, inflation has been absent, even with lower unemployment. This suggests the Phillips curve is dead!  The reason? China’s rise as the world’s factory. Its manufacturing exports have gained critical mass in world trade since around 1995.
Meanwhile, the forces that drove US consumer prices higher after the 1970s, including US dollar depreciations, oil price spikes and cost-of-living adjustments for manufacturing workers (which were passed through to the consumer price index (CPI), have all disappeared.
Such structural factors signalled that full employment was not the culprit driving up inflation in the first place, so the low unemployment rate of the late 1990s did not bring back inflation.  Arguably, the world’s adjustment to the post-GFC balance sheet recession, which did not ended even in the run-up to the COVID-19 crisis, has been an additional force curbing inflation. 
China adds disinflation, not inflation
China’s role as the world’s leading purveyor of manufactured consumer goods added a significant disinflationary force into the mix. As the world adjusted to the pandemic, China did not take advantage of high US demand to raise prices despite rising PPI inflation at home. In my view, this is because:
1) Chinese manufacturers fear losing global market share
2) Chinese firms do not, as the market assumes, always maximise profits. Rather, they aim to maintain social stability and output growth, preserving market share and, more recently, reducing costs through new technologies.
Instead, China has been absorbing much of the PPI inflation, not passing it on to consumers (see exhibit 1). Inflation has squeezed profit growth from all sides.
The inflation outlook
Generally, global households (also in China) are not suffering from a shortage of goods and services, but a lack of confidence. Whether banks lend and people borrow depends on their assessment of the economic outlook. Weak confidence damps loan growth despite central bank liquidity injections.
In China, systemic confidence has been hurt by uncertainty stemming from
- structural reforms
- anti-corruption campaigns
- a change in the macroeconomic policy objective to deleveraging from ‘growth at all cost’
- Beijing’s retreat from the implicit guarantee policy and the risk of more corporate defaults and bankruptcies.
When economies, China’s included, reopen, price pressures from supply bottlenecks due to COVID-19 disruptions will clash with the post-pandemic recovery in demand. However, they should fade when economies have normalised in the absence of wage-price spiral pressures. Therefore, inflation volatility can be expected to rise in the coming months, but it may not be sustained.
1) Much of the fiscal spending will go towards savings and debt repayment, constraining inflationary pressures.
2) Some of that money will go to goods and services to satisfy the pent-up demand; this is boosting inflation in the short term.
3) As for the rest (which includes money that has gone into saving), a good part will go to buying financial assets and even property.
The latter is positive for asset prices once the short-term volatility in inflation has faded.
As for China, in an environment where the credit impulse is declining and inflation is squeezing corporate profit growth, pricing power and margins will be crucial factors for stock performance. Stocks of companies with great pricing power and strong margins will benefit.
For more on the debate about the outlook for inflation, read Our thoughts on inflation – And why we just don’t buy it! and Weekly investment update – Higher inflation everywhere
 See Harvey Rosenblum (2000), “The 1990s Inflation Puzzle”
 Chi Lo (2009), “Asia and the Subprime Crisis – Lifting the Veil on the ‘Financial Tsunami’ ”, and Chi Lo (2010), “China After the Subprime Crisis – Opportunities in the New Economic Landscape”
 See “Q-Series: The Inflation Compendium – What Are the 10 Most Critical Market Questions? (Part 1)”, UBS Global Research, March 2021
 See also Chi on China: The Crypto-Renminbi’s Disruption to the Market, Economic Growth and Policy”, August 2020.