Inflation in the world’s major economies has accelerated to rates unseen outside of the 1970s oil price shocks. Consumer price index (CPI) inflation in the G7 group of "rich nations" hit 5.9% in February (Chart 1).
The combination of pandemic-induced supply-chain disruptions, the rebound in demand as economies re-open, tight labor markets and the commodity supply shock from the Russian invasion of Ukraine will mean inflation remains elevated, even if headline rates are close to a local peak.
Chart 1: G7 CPI is high
Chart 2: Real household income growth is negative
Meanwhile, although wage growth has increased, aggregate wages have failed to keep pace with higher prices.
The upshot is the sharpest drop in G7 household real disposable incomes in at least half a century — surpassing even the 1970s. This squeeze on real incomes will have ongoing political ramifications that matter for investors.
French, UK elections — first major electoral skirmishes in high-inflation era
While Emmanuel Macron won re-election in the recent French presidential elections, the strong showing by his rival, Marine Le Pen, points to the political salience of inflation.
Le pouvoir d’achat was a major concern for French voters (Figure 2). Le Pen was able to pivot her campaign away from immigration and European membership, towards the cost of living, in a way that helped her detoxify her image.
Meanwhile, Macron’s second-term agenda has been pared back — pension reform has proved particularly controversial against a backdrop of rising prices.
Chart 3: Cost of living most important in French presidential election
In the UK, the poor showing by the ruling Conservative party in May’s local elections was at least partly due to rising cost-of-living issues.
These issues are all the more challenging given that seemingly attractive fiscal responses being considered by the government, such as a value added tax (VAT) cut or fuel-bill rebates, could add to inflationary pressures and make the problem even worse.
US midterms next key flash point where inflation and politics clash
Over in the US, November’s midterm elections are likely to see the Democrats lose control of the House of Representatives and the Senate (Figure 3).
While a President’s party often performs badly in midterm elections, the Democrats’ poor polling is in part due to the Republicans’ success in using inflation against the administration of President Joe Biden. Indeed, Republican voters appear to be more concerned about inflation than Democrats.
Chart 4: Republicans leading in Congressional polls
Chart 5: Expected change in prices next year, by political affiliation (%)
High inflation has already helped stymie the administration’s "Build Back Better" agenda, as Democratic senator Joe Manchin resisted legislation which would be stimulative amid rising prices.
Losing control of both Congressional chambers would kill any chance of reviving Biden’s agenda, and would increase risks around government shutdowns due to political bickering over funding.
Impact on emerging market politics could be even worse
In emerging markets (EMs), food and energy together form a much larger share of household spending. For example, it’s more than 50% for many people in India. Income inequality is generally greater in EMs as well, while institutions are often less mature and more fragile. Moreover, government balance sheets are weaker, while social safety nets are less adequate.
A potentially worrying historical parallel with the current cost-of-living crisis is the Arab Spring protests of 2010-12, triggered in part by the post-Global Financial Crisis (GFC) surge in inflation, particularly in the price of food (Figure 4).
Those protests were followed by political, economic and financial market turmoil which, in some cases, persist today.
Chart 6: EM food price inflation elevated
Source: Haver, abrdn Research Institute, as of May 3, 2022.
Social unrest has already flared up in a range of EMs including: India, Chile, Peru, Colombia, Ecuador, Argentina, Kazakhstan, Morocco, Sri Lanka, Pakistan and South Africa.
Many of these countries have weak government balance sheets and a range of idiosyncratic political issues. But further protests around cost-of-living issues will make it difficult for governments to push through austerity measures, keeping country risk premia high.
Implications for investors
While much will depend on how persistent higher inflation proves to be, we think the important implications for investors are:
- Firms may face political scrutiny around pricing and market power. This could involve blocking mergers and breaking up entrenched market power; moral suasion to stop firms increasing prices, squeezing margins; direct regulation of prices as is already occurring in the energy sector of many countries; and windfall taxes on sectors like energy.
- When facing shocks that simultaneously push up inflation and push down growth, central banks may put greater priority on inflation stabilization than before. This is because there may be less political support to "look through" high inflation. This would tend to lower growth and make policy less supportive of asset prices during negative shocks.
- Significant fiscal easing may be less likely in future downturns. The experience of high inflation following the pandemic-related fiscal easing could stigmatize fiscal policy as a source of demand stabilization. This means that monetary policy would return to being the main stabilization tool, risking future episodes with rates at the lower bound.
- Political pressure on incumbent parties and established institutions is likely to lead to greater policy volatility and a higher political risk premium attached to financial assets. This is particularly the case in those EMs where we have highlighted social stability concerns.
- National energy policy will primarily be driven by security and price considerations, and only secondarily by climate commitments. These can work in the same direction in Europe. This means a smaller role for gas and oil and a larger role for nuclear and renewables. But security and cost-of-living considerations may be at odds with a transition to low-carbon energy in the US, China and India.
- While this period of high inflation has increased concerns that we are moving to a long-run paradigm with persistently higher inflation, the fact that inflation is once again proving so politically toxic actually helps increase our conviction that over the long term, policymakers will not allow the economy to transition to permanently higher inflation.
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