The 8 Forces of the New Inflationary Regime

Since 2008 extremely loose financial conditions have sparked inflation fears among investors at different points in time. Those expectations, however, did not materialize on a sustained basis.

In the aftermath of the 2020 pandemic, a groundswell of structural and cyclical forces are undermining the sustainability of the "lower-price regime". By becoming increasingly interconnected, these drivers might be setting the perfect conditions for meaningful and lasting inflation.

On this post I describe the 8 economic, sociological and political factors that, I'm afraid, will lead to a major turning point in the history of inflation:

1.) Commodities on the Rise
2.) Supply Bottlenecks
3.) Wage Growth
4.) Tax Increases
5.) Increasing Financial Costs
6.) Rising Protectionism
7.) Fiscal Stimulus and Interventionism
8.) Central banks to tolerate higher inflation
Conclusion

1.) Commodities on the Rise

While the post-pandemic economy is bouncing back, the growing demand is creating pressure on the mining capacity. As a result a range of base and precious metal prices have exploded, including nickel, lithium, iron, silver, steel and copper prices.

As for agricultural commodities, structural and cyclical conditions such as rising incomes, population growth, extreme weather, water shortages and rising trade restrictions are driving the market price up.

CRB Commodity Index Chart since 2012 to 2021
CRB Index is calculated using arithmetic average of commodity futures prices

2.) Supply Bottlenecks

The overall supply chain capacity is being tight due to a number of factors:

  • soaring material prices
  • shortages of key components
  • supply chain delays
  • tight capacity from Asian suppliers

News headlines have been covering some striking disruptions like the global shortage of shipping containers or the lack of semiconductor microchips. However, a broad range of economic areas are being impacted. For example, initially concentrated in the auto sector, the microchip crisis has now spread to other consumer electronics.

No doubt that the supply chain capacity is tight. For now it can be viewed as a transitory inflationary pressure, but a rebound of demand after the pandemic could exacerbate the squeeze.

3.) Wage Growth

Most evidence points to a growing imbalance between job openings and job seekers, which means it is getting harder, and more expensive, to fill the required jobs.

There are a number of factors are behind of this mismatch:

  • A new set of specific skills is required to meet the needs of the technology boom.
  • Unemployment benefits and stimulus programs do not encourage job seekers to accept lower paying jobs.
  • The US and some European government are trying to reduce inequality by promoting higher salaries.
  • Employees across the developed world are having to deal with higher costs on several fronts, including housing, energy, healthcare and education.

4.) Tax Increases

The US is planning to raise corporate and personal income taxes. While tax hikes might not have an imminent effect on the economy, they may change long-term and medium-term business decision, including investment plans and pricing policy.

While some companies may be able to raise prices to compensate for those higher taxes, others may experience a profit margin squeeze.

5.) Increasing Financial Costs

After to many years of loose financial conditions, an increasing number of companies are relying on low borrowing costs. However, if inflation starts to pick up, the most indebted ones will suffer. In order to survive, they may have to pass along those higher financing costs to consumers.

6.) Rising Protectionism

Competitive price cuts across the developed world have been driven by technology advances, free trade agreements and globalization. Most recently, however, growth in trade operations are slowing down due to a number of factors:

  • Many European and American voters consider that globalization has led to the loss of many well-paying jobs.
  • Donald Trump changed the US trade policy by raising import tariffs and changing several free-trade agreements. So far, this confrontational trade policy has not been changed under the Biden administration.
  • The European Union is targeting big tech players by enforcing antitrust laws.
  • International tensions are being reactivated across the world:
    • The mutual distrust between China and the US is deepening over time.
    • Tensions between Russia and Ukraine is rising.
    • While the leadership of the US is declining, China and Russia could be teaming up to test the Biden administration.

7.) Fiscal Stimulus and Interventionism

Most governments across the world are being closely followed by their constituents. In order to be reelected, they have to make sure that the recovery takes hold, which means they will try to roll out massive fiscal stimulus packages.

The stimulus tide is not behind us yet. There is a lot of stimulus in the pipeline, but if governments push too hard, they can overheat the economy and get inflation.

In addition, the implementation of such a range of social and environmental plans requires a new regulatory framework which may undermine free market principles and competitive pricing.

ESG

There is a groundswell of environmental, social and corporate governance (ESG) policies, particularly in the most developed countries. The main focus in Europe has been on the environmental part of the equation (E) while the social issues (S), including diversity and inclusion, has been gaining popularity in the US.

Democrats in the US and some European lawmakers are relying on social policies to reduce inequality and support economic growth. Higher minimum wage, increasing unemployment benefits, and universal basic income are now major components of the political debate.

Infrastructure Spending

The Biden Administration is trying to push over a trillion dollar package in infrastructure spending. While it remains to be seen its short-term and long-term impact on the economy, there is little doubt that the rollout of the plan will have a meaningful impact on aggregate demand and wages.

8.) Central banks to tolerate higher inflation

In a major policy shift, the Fed has recently adopted a "flexible" inflation target strategy based on "averages" while saying that they expect transitory price increases. Put it simply, they are going to sit on their hands while inflation is picking up. The European Central Bank is following a similar, albeit more moderate, communication approach.

Why are their communication strategy is being so dovish?

  • The world's biggest central banks need higher inflation rates to deal with the gigantic public deficits.
  • Central banks do not expect abrupt or lasting inflation changes out of the recent monetary expansion and fiscal stimulus policies.
  • After being able to successfully manage the critical moments of the pandemic by using aggressive monetary measures, central banks seem more confident. It is like they had concluded that being reactive is the way to go. Their job now is to be a firefighter rather than follow uncertain prevention guidelines which have proven to be ineffective in the past.

Conclusion

The most recent data show that companies are facing with mounting input costs on several fronts. During the last decades we have seen how retailers have absorbed temporary price increases, so the impact on consumer prices have been relatively subdued.

In the new post-covid era, retailers will be able to keep the low-price model only for a limited period of time. But sooner or later, companies will have to pass through those costs, putting a dent in customers' wallets.

In the end it is not just higher costs but the wide range of factors that are becoming increasingly interconnected to set off, probably, a meaningful and lasting inflation trend.

Macro Guy

Macro Guy