The return of the spectre?

„The question to be asked – the danger to be recognised – is how inflation, however caused, affects a nation: its government, its people, its officials, and its society. The more materialist a society, possibly, the more cruelly it hurts.”

– Adam Fergusson in ‘When Money Dies’

Besides the occasional coverage on (hyper-) inflation in Venezuela, Western spectators have been largely spared the phenomenon in recent years. Globalisation and technology have come to be seen as deflationary laws of nature. This led some to even ponder whether inflation is dead.

Yet after more than a decade of ultra-loose monetary policies and a pandemic later, has the spectre of inflation risen from the dead? Recent developments in the US seem to suggest so. The US consumer price index (CPI) showed a 5.4% annual jump, marking the fastest uptick since August 2008.

The latest developments have opened an interesting debate on the nature of inflation. Is it merely “transitory”, driven by short-term factors that will soon abate, as the FED continues to proclaim? Or, will it prove to be more “enduring” due to structural factors at play?

Jerome Powell, the Fed’s chair, continues to assure observers that the Fed is carefully monitoring inflation and that there is no need to worry. Joe Biden recently came to his side:

“The reality is you can’t flip the global economic light back on and not expect inflation to happen”

Powell continues to assert that the recent inflation increases can be attributed to a pretty narrow group of thingsthat will soon fade away. This group of things includes supply-chain shortages (wood, steel), price normalisations in COVID-hit domains (tourism, flights) and pent-up demand (now being unleashed).

The development of the price of lumber seems to favour Powell’s hypothesis – at least for now.

As a result, Powell’s modus operandi is “wait-and-see”. The rationale behind this approach is COVID-19. More specifically, the Delta variant. The Fed is cautious in managing the balancing act of the recovery: if it slams the brakes too early, it could it jeopardise the recovery at a critical stage. If it’s too late, inflation could spiral out of control. For now, Delta trumps inflation.

However, given the noisy nature of the debate, it’s crucial to look at what the other side of the argument is saying. Their hypothesis rests on the belief that inflation will prove to be more enduring due to “structural factors” at play.

Some point to the inherent gap between demand and supply, which we currently witness. As a result of the unprecedented stimuli and rapid growth in broad money supply, consumers have more money to spend. Mohamed El-Erian, Chief Economic Advisor to Allianz, warns that the production of certain goods may remain constrained far longer than expected.

Others note that the reopening of the US-economy has outpaced the capacity of companies to hire new people. Corporations ranging from Amazon over BlackRock to Chipotle have already increased wages. What’s more, a labour mismatch of skills might arise. As the economy continues to become more tech-savvy, not all people may come back to their old-jobs. Some jobs may have become ‘rationalised’, while others may require more technical qualifications. Parts of the workforce might find out they don’t have the right skills anymore, causing the overall labour force to shrink. In the short-term (with a lower supply of skilled labour), this could cause further upward wage pressure.

Last but not least, Warren Buffet alluded to third structural factor during Berkshire Hathaway’s recent AGM:

“We are raising prices. People are raising prices to us and it’s being accepted.”

Since the last financial crisis, whenever there were higher input costs, companies shrank their margins. Yet today companies with pricing power (e.g., from the tobacco, software, food retail and luxury goods sector) pass the higher input costs on to the consumers, which in turn gets reflected in the CPI.

So, what to expect in this noisy and at times ambivalent environment?

An interesting development could be witnessed on the other side of Atlantic. The ECB recently adjusted its inflation target to 2% over the medium-term giving it more room to keep rates “lower for longer”. The FT was quick to notice that this marks “an important break with the conservative monetary doctrine of Germany’s Bundesbank that formed the bedrock of the euro’s creation.”

In the US, the Fed’s dual mandate of full employment and stable prices provides insights. During last week’s Congressional hearings, Powell was adamant to notice that “there is still a long way to go” in the labour market. It’s still 7.5 million jobs away from its pre-pandemic level. Thus, expect the Fed’s monetary policy to remain in place for now.