The rise in government bond yields since the beginning of the year is, for many observers, a sign of an imminent increase in inflation. After having declined gradually since the early 1980s, low inflation became entrenched after the Global Financial Crisis, but its reversal may now have begun. In support of this view, some emerging countries, such as Brazil, Russia, and Turkey have already seen inflation rise and their central banks have reacted by raising interest rates.
Factors behind the rise in inflation include the exceptional policy measures undertaken by central banks and governments to combat the Covid pandemic and the strong economic recovery that is underway which has been associated with rising commodity prices. How important are commodity prices for consumer prices? Commodities are inputs into manufactured goods that are eventually purchased by households, however, other factors, including the costs of labour and capital and taxation are more important than raw materials in setting the final selling price.
A simple model was used to assess the interaction between the business cycle, commodity prices, and inflation in developed and emerging countries. The observation of how the model variables respond to a standard shock highlights several interesting results:
- Business cycle improvements and commodity price increases are followed by higher inflation in developed and emerging countries. The impact of shocks to the business cycle and agricultural prices is more persistent than that of energy price shocks.
- The response of inflation to a shock on agricultural prices is stronger in developed than emerging economies after a shock on activity and energy prices. Furthermore, in emerging economies, the estimated impact of a shock to economic activity is barely significant. One explanation of this counterintuitive result is that emerging market currencies tend to appreciate when the global business cycle improves, thereby dampening the inflation response to activity shocks.
- The energy price shock is transmitted faster than the agricultural goods price shock.
- At the peak, the transmission of an energy price shock is about twice as high in developed as in emerging countries. In contrast, the response after an agricultural prices shock is similar in the two country groups. These results may be surprising considering the higher weight of these goods in CPI baskets in emerging than in developed countries. However, in several emerging countries commodity-related prices are centrally managed to preserve household purchasing power - commodity price shocks are absorbed into public accounts.
- Considering the size of the three shocks recorded from December 2020 to April 2021, the expected impact on median inflation in developed and emerging countries is moderate.
Conclusion
To conclude, these results support the view that despite the strengthening economy and large increases in energy and agricultural commodity prices, their impact on inflation in the coming months will be contained and will be largely absorbed within a few months.