The long-expected end of easy money seems to be upon us. In the past couple of weeks, the Bank of England has raised rates, and the US Federal Reserve has indicated a swifter tapering of its asset-buying programme and as many as three rate hikes in the year ahead. All this is predicated on the idea that “transitory” inflation is becoming more permanent, moving from commodities and durable goods into areas such as wages and services.
A lot of the debate on growth, inflation and stock markets has been about the secular shifts that we may or may not be entering. But what if the only constant in the next few years is volatility? What if inflation dynamics that seem entrenched begin to oscillate? I think you can argue this will be the case for a number of reasons.
First, the ripple effects of the pandemic have created an inflationary environment unlike in the 1970s, the last time the US had a prolonged period of inflation. Covid has created a series of asynchronous recessions and recoveries around the world. The US is running “hot”, but China, which has been trying to deflate its property and debt bubbles, has cooled off. The fact that these two poles of the global economy are decoupling, not only in terms of trade and capital flows, but also their growth pictures, makes it tougher to predict how inflationary pressures will play out.
This is just one of the many factors behind what investment research provider TS Lombard has dubbed the “biflation” trend, in which multiple supply and demand factors push and pull against one another in unexpected ways. For example, while the world has adjusted to the sudden “high Covid” demand for all things digital, as well as pandemic-specific goods like medical equipment, personal protective equipment and home goods, there may still be some post-Covid-19 supply shocks in services, which had little reason to invest over the past two years, leaving scant spare capacity.
That has already led to wage pressure. In the US, where services make up the majority of the economy, companies expect wage costs to be up 4 per cent in 2022, as salary budgets reach a 14-year high, according to the Conference Board, a think-tank. There’s a generational complexity to all this. “Soaring wage growth among younger workers in particular has compressed the typical premium offered to more experienced employees — who are, in turn, seeking out new opportunities in a hot job market”
At the same time, companies may be in for a round of price commodification that will also depress profit margins. While there was huge demand for goods over the past few years, we may soon see an inventory glut at manufacturers and retailers, as retailers guard against over-purchase. A December Deutsche Bank research report noted that “retailers are over-ordering ahead of the busy holiday period” while “manufacturers are producing and holding far more inventory than they did before Covid”. According to the Bank for International Settlements, “the mechanical effect on CPI could well turn disinflationary” as supply-chain dislocations and “precautionary hoarding behaviour” wanes.
This would inevitably cause deflation in goods, even as there’s inflation in services. The sharpest upward shift in spending in the past year has been in areas such as out-of-home entertainment, restaurant meals, cinema and theatre. But that, too, can change quickly based on the trajectory of Covid-19 variants, as those of us with cancelled holiday plans have seen.
All this is creating what the BIS recently dubbed a “bullwhip effect”, in which efforts to fix immediate inflationary issues create their own complex, delayed ripples that further distort prices. The geopolitically driven shift from efficiency to resilience in supply chains, which will favour everything from localised production to new sovereign-backed digital currencies, will further hamper economists trying to model inflation with the data from the past half century.
Technology is the final wild card. Artificial intelligence means it can do more of what humans can; 5G and the internet of things are increasing business efficiency. Both are deflationary. But that’s just part of the story. Remote work, for example, lowers commercial property prices but raises those of homes. Robot installations (up 12 per cent this year in the US) will be good for companies trying to keep prices down, but bad for the unemployed faced with spikes in fuel and food costs.
The upshot? I think we’re likely to see back-and-forth messaging from central bankers struggling to figure out where things are heading next. Add in the historic issues of debt and asset bubbles from decades of falling rates and unprecedented quantitative easing, and you have one of the most complex environments in which to make monetary policy. If anyone deserves a pay rise, it’s the people trying to figure out where inflation is heading.