Welcome to the new age of inflation

June 27, 2022

Inflation is undoubtedly the centre-stage topic right now. What’s up for debate is whether the ongoing surge is likely to be permanent or transitory and whether central banks need to react or adopt a more relaxed approach.

Developed market (DM) central banks seem to be in the transitory camp, perhaps as a reflection of their experience of several decades of low inflation, or even grappling with the challenges of deflation.

The reaction function of emerging market (EM) central banks is more heterogeneous. A number – including Russia, Czech Republic and Brazil – are pre-emptively hiking, and aggressively at that. Others like South Africa appear willing to wait and see.

To set out my stall, I’m of the view that we are experiencing a paradigm shift on inflation – and we are facing a perfect storm that presents the biggest risk of a sustained and extended period of inflation not seen since the 1970s.

But perhaps it’s first worth setting out the case made by the “inflation is transitory” camp, which will help me better attempt to debunk this view.

The basis of the transitory argument is that while supply chain disruptions caused by Covid will spike inflation in the short term, all the forces that drove inflation lower through the 1990s to the period immediately before Covid remain intact and will inevitably force inflation to mean revert to very low levels. Think here of very powerful forces, including globalisation, free trade and the application of technology to supply chains and markets.

The transitory group would add that Covid has seen millions of people left unemployed or temporarily parked outside of the labour force through furlough schemes, but as wages begin to rise they will be encouraged back into work, capping wage pressure and core inflation. They would also argue that global output is close to pre-pandemic levels, but in the US at least is being produced by fewer people, hence technology is doing its thing to keep the supply curve moving out right.

A mea culpa herein is perhaps there have been many voices that cried wolf on the inflation front in recent years, but all have been disappointed.

I would argue that something is very different this time around.

Why do I think the current spike higher in inflation will prove long(er) lasting?

Because a perfect global storm is brewing.

  1. Covid continues to cause disruptions to finely calibrated supply chains, many of which are interconnected. Prices are rising and fast – but will this prove long-lasting?

    The transitory crew would argue that market forces and technology will quickly see markets and prices settle, and much lower. I would counter that supply shocks will more likely last many months, if not years. This already seems to be proving to be the case. A year on from the first price shocks and prices are still on the up.

  2. Expanding on this first point, Covid seems to be changing a whole range of demand and supply factors and shifting both curves across multiple industries as not seen since perhaps the 1970s.

    In response to Covid, we are changing where and how we work and live and what and where we consume. Companies are dying and being born as a result. The cards are all being thrown on the floor and it will take time to pick them up and reorder the pack. During this time, shortage seems to be the dominant theme.

  3. Covid hit as the world grappled with the challenges of climate change and efforts regarding energy transition. Climate change has brought challenging agroclimatic conditions in many parts of the globe, causing disruptions to agricultural production and food supply. Food prices are near historical highs. Climate transition has been mismanaged (we are all guilty) and this winter we have seen the impacts of that in European gas and energy markets.

    The immediate challenges of climate change suggest that the carbon transition will be disruptive and energy shortages could prove longer lasting, not helped by geopolitics.

  4. Linked to the carbon transition, ESG has exploded. The hope is that attention on ESG factors will raise standards globally, but likely will increase costs across the board, shifting supply curves up and to the left. Arguably, the carbon transition will do something similar until a critical mass of investment in renewables is reached to fully take the strain from carbon.

  5. The rise of populist politics, mixed in with geopolitical competition and tensions, means that the trend is no longer towards ever-freer markets, but towards greater trade autarky. This means more regulation, a desire to onshore more production and use tariffs and tax policy to deliver on this.

  6. We cannot ignore that the US and China are in a battle for hegemony. It’s hard to see this trend reversing when both now see the relationship being based on wanting to see the other fail. Other countries are having to choose which side they are on, but the result is likely to be less globalisation, less free trade, more regulation, tariffs and higher costs of production all around.

    And the battle for hegemony is not only between China and the US, but also Russia and the West. Russia has sought to use its energy trump card against Europe, limiting supply into storage through the summer to leave Europe with high gas prices this winter. Perhaps Russia ultimately sees the carbon transition as killing the ‘golden goose of energy exports’ and that now is the time to use leverage for strategic gains over Ukraine.

  7. The policy response to Covid has been exceptional. Central bank balance sheets, which had already been greatly expanded because of the global financial crisis, have been further inflated. Fiscal policy has been massively loosened. Both are slow to be reined in.

  8. ‘Group think’ in DM central banks that the current inflation splurge is transitory appears to be based on conclusions drawn from recent history, but which seems to have no relevance to the post-Covid environment. DM central bankers still seem to be operating in the post-GFC environment, perhaps with the mindset that growth and jobs must be prioritised at all costs so as to head off the risk of populist backlash.

    It is likely that DM monetary policy will remain looser for longer, and although EM central banks appear to be waking up sooner to smell the coffee, the reality is a decade of QE, or cheap DM money, has seen resource and credit mispricing globally and acted to put less pressure on EMs to drive ahead with much needed structural reform.

In conclusion, I would argue that the case for inflation to be sustained at higher levels for longer is compelling. We are living through a new paradigm, a shift occurring in so many plates but working to the same likely effect, higher prices.

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