After three decades of absence, the spectre of inflation has returned to haunt the world. The Ukraine crisis has precipitated a spike in energy and food costs which is causing immense pain all around the world. But a faster pace of price increases was already evident even before Russia invaded Ukraine.
Some analysts are now worrying that we are returning to the stagflationary days of the 1970s when the world suffered from both rapid price increases as well as mediocre economic growth.
Our view is that the inflation we are likely to suffer in the coming years is a very different beast from that of the 1970s: it is in a sense a new form of inflation.
In fact, there are two distinct types of inflationary challenges. Although related to each other, they represent different phenomena with divergent implications for businesses and investors.
One type of inflation meets the standard definition of inflation — a general rise in the absolute level of prices, across the board and affecting most goods and services. The surge in this standard inflation should peak by the year-end and then recede. But average inflation will then still be higher than what we have experienced since the 2008 Global Financial Crisis. This is because of the second dimension of rising prices, one that results from structural factors which will raise costs in some goods relative to others — or what economists term a change in relative prices.
The rise in energy prices and material costs relative to other prices is not likely to reverse: this price increase is part of a necessary adjustment to structural shifts in the world economy such as the need to de-carbonise the world economy.
Inflation has risen, will peak soon but …
Standard inflation is the product of demand exceeding supply. Often this is caused by central banks allowing too much liquidity to be created or governments over-spending by running large budget deficits. There can also be periods when major dislocations in supply chains cause prices of many goods and services to rise. These conditions have been present in recent years, so it is not surprising that inflation has perked up.
• Central banks across the world responded to the economic crisis caused by the pandemic by loosening monetary policy – sharply cutting interest rates, sometimes to negative levels even. Several major central banks mounted “quantitative easing” which pumped massive amounts of money into the system. This policy supported helped to prevent an economic collapse but may have been kept on for too long, contributing to excess demand,
• Governments, especially in developed economies, also ran very loose fiscal policies. Spending was massively ramped up to provide support to consumers and businesses that were floored by the pandemic. This, too, was necessary — but the loose fiscal positions may also have been kept on for too long. This may have aggravated the excess demand already created by the loose monetary policies described above.
• At the same time, there were also supply-side disruptions. Labour shortages drove up wages because of temporary factors such as older workers staying away from work, scared of being infected by Covid-19 or working mothers being forced to stay at home because childcare centres shut down during the Covid-19 infections surge. Separately, the lockdowns and restrictions on activity imposed during such surges in infections also led to bottlenecks in production (as factories were forced to go slow on manufacturing activities) or in transportation (as ports became clogged up and goods could not be delivered on time).
• The final twist came when war broke out between Russia and Ukraine and drove up the prices of food and energy. Between them, the two protagonists in the war produce sizeable proportions of the world’s oil, natural gas, wheat, barley, sunflower oil, nickel, palladium and neon gas (used in electronics manufacturing).
As prices of these commodities rose, there were knock-on effects in the prices of their substitutes — for example, palm oil prices also surged because palm oil competes with sunflower oil. Even where the supply of these commodities remained sufficient to meet demand, the fear that eventually the supply would be compromised caused a risk premium to emerge in their prices. So long as people fear the risk of supply interruptions, prices will remain elevated.
Given these determinants of inflation, what is the likely outlook? It seems to us that inflationary pressures will ease over time.
First, monetary and fiscal policies are being tightened. On the monetary front, the US Federal Reserve Bank has just raised interest rates and has vowed to step up the pace of rate increases aggressively. The Fed will also cut back on its quantitative easing programme. Other central banks such as the European Central Bank and the Bank of Japan have also committed to tighter money while several other central banks in both developed and developing economies have already been raising rates.
In addition, now that the pandemic crisis is ebbing governments are also cutting back on fiscal largesse, meaning that the governments’ fiscal operations are actually taking demand out of the system.
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Second, as the pandemic ebbs, restrictions on activity are being eased rapidly. That is helping to improve the functioning of supply chains, enabling supply to better match demand. Except in China and Hong Kong, governments everywhere no longer have much appetite to impose stringent limits on activities.
Even in China, policymakers are now more calibrated in their approach so as to limit the damage to supply chains. We believe that many workers who left the workforce at the height of the pandemic are likely to return — as the risk of infections diminishes and as government handouts are also slashed.
Finally, much will now depend on how long the war-induced price increases affecting oil and some important food items will last. In a scenario where the intense phase of fighting ends within a few months, then the risk to critical supplies of oil, gas and food will diminish by the second half of the year. Russia is suffering military setbacks and will face withering economic damage in the coming months.
In our baseline scenario, there will be a growing incentive for Russia to negotiate a settlement as the months’ pass. Moreover, the current level of oil prices makes a compelling case for American shale oil producers to ramp up production. Oil exporting countries such as Saudi Arabia and the United Arab Emirates have the capacity to step up production as well and will do so with time. On this basis, our best guess is that oil and food prices will ease considerably by the year-end.
… then remain at levels higher than in the past 20 years
In short, we, therefore, believe that the most recent spike in inflation will run its course in the latter part of this year as the threat of supply disruptions eases and as monetary and fiscal policies which create excess demand are reined in.
Then the question is — does inflation return to the low levels that we have enjoyed since the global financial crisis of 2008?
We doubt that. Inflation rates are likely to fall from their current elevated levels but will then prevail at levels closer to what we saw in the 1990s, i.e., around 2.5%–3% in developed economies. The reason is that the factors that helped keep inflation low are no longer as potent as before:
First, the long-lasting fall in unit costs as production shifted to lower-cost China is over. Chinese costs are rising now, limiting the improvement in cost efficiencies to be gained by relocating production from high wage economies to China. Moreover, political compulsions are limiting further shifts. Indeed, for strategic reasons, governments in developed economies such as the US are now pressing for critical items such as electronics and pharmaceuticals to be manufactured at home, even if costs are higher.
Second, the push for de-carbonisation is only just getting started and it will be costly. For example, the carbon price that many countries are imposing will be progressively raised over time. The shift to a green economy also seems to be reducing investment in fossil fuel production — even though the world will remain dependent on coal, oil and gas for a long time. Without adequate investment, there will be less supply over time and the cost of energy may keep rising. All this will feed into a higher cost structure.
Third, the political pendulum is swinging back in favour of labour and against capital. For almost 40 years, capital gained power over labour. Weaker trade unions were unable to advance workers’ rights and the outcome was persistent weakness in wage growth across developed economies. Now, governments are raising minimum wages and pressing for expanded perks such as more extensive paid medical leave — wage costs are certain to push up price pressures as a result.
Conclusion — major implications for markets and economy
Several implications arise from this new inflation.
First, with inflation generally higher than before, there will be less room for central banks to pursue easy monetary policies. In the near term, it is clear from Fed Chairperson Powell’s comments that the American central bank is in a mood to raise rates more aggressively than investors had originally anticipated.
This means that there is a high chance of significant asset price corrections wherever there are stretched valuations — certainly, companies whose business models are not tried and tested and which relied on easy money to survive will come under painfully rigorous scrutiny. In general, there will be less support for asset prices from low rates and easy money in future.
In the longer term, as inflation will tend to be higher and more variable than before, there could be a higher chance of central banks misjudging inflation risks. Monetary policy in emerging markets such as in our region will be watched closely and markets could be more unforgiving of policy errors made by our central banks.
Second, the different mandates given by their political masters to different central banks will lead to divergent approaches to monetary policy and inflation. We suspect that the European Central Bank and the People’s Bank of China will tend to be more rigorous in tackling inflation compared to the Fed in the US which has a dual mandate to balance both inflation risks as well as unemployment risks. That could mean that over time, inflation is higher in the US compared to Europe and China and that the US Dollar may weaken as a result relative to those other currencies.
Third, over time, businesses will respond to the structural factors that push up costs. As wage costs go up, companies will invest in labour-saving technologies and corporate restructurings to reduce costs and preserve their profit margins. This will eventually produce higher productivity growth and lower unit costs.
In short, the inflation outlook will matter greatly and in many ways for investors, consumers and businesses.
Manu Bhaskaran is CEO at Centennial Asia Advisors