The trajectory of inflation going forward remains of crucial importance to investors. The encouraging start to the year for global equity markets is, in part, down to the expectation that inflation will fall back, thereby allowing central banks to halt their cycle of interest rate hikes and potentially ease monetary policy before too long.
We have argued that over the course of 2023, there are good reasons to expect a sharp decline in inflation in the Western advanced economies; favourable base effects, easing supply chain disruptions, elevated inventories and cooling demand should see headline rates decline towards central bank inflation targets later this year (see our commentary of January 2023).
A bigger question is whether we are seeing a more fundamental, structural shift in price dynamics over the longer term, that is once the elements of inflation related directly to the pandemic and the war in Ukraine (e.g. volatile shipping costs, spike in energy and food prices etc.) dissipate. In this month’s article we take a look at some of the factors that might suggest we are entering a period of structurally higher inflation.
Demographics/labour markets
Although headline inflation in the US and Europe is now falling back, central bankers have increasingly focused their attention on core measures of prices (i.e., excluding food and energy) which have proved more stubborn. In particular, inflation in the services sector (i.e., hospitality, healthcare, hairdressing, leisure etc.) continues to run at historically high levels, a development which policymakers have linked to strong growth in wages, which tend to make up the largest input cost in the sector1.
To be sure, there is some evidence to suggest that expanding corporate profit margins have been a key factor behind the surge in inflation in recent years2. However, over the longer term, it is also true that current rates of private sector wage growth (in excess of 6% in the US and the UK34) are incompatible with central banks’ 2% inflation targets given lacklustre productivity growth.
Workers have been able to bid up wages partly as a result of a shortfall in the supply of labour relative to demand in recent years. Several factors lie behind the shortage of workers. According to the World Health Organisation (WHO), over 6.8 million people have died from Covid5. What’s more, many workers have withdrawn from the labour force as a result of long-term illness, related in part to the fallout from the pandemic and backlogs in the healthcare system. In addition, there has been a surge in early retirement, as workers reassess their work-life balance. Some observers also point to insufficient levels of immigration as a factor in reducing the supply of workers6.
A key question going forward is whether this shortage of workers will persist. The waning of the pandemic, along with improvements in healthcare and rising wages might cause more people to rejoin the workforce. However, the fact that many societies are ageing suggests that the tendency towards a decline in the overall share of the working age population will be more persistent. Pensioners will continue to consume goods and services, running down their savings, but will not contribute to aggregate supply.
As a result, some economists have argued that workers will experience an increase in bargaining power which will lead to a sustained increase in wage growth and inflation. Indeed, a 2018 study by the Bank for International Settlements (BIS) concluded that the higher share of working age population was responsible for a decline in inflation in the US of around 7 percentage points between the 1970s and the 2000s, while also predicting that demographic shifts would put upward pressure on inflation during the coming decades7.
Of course, governments could try and head off the potentially inflationary repercussions of demographic changes by, for example, trying to get workers to work for longer and facilitating increased immigration of young foreign workers. However, such policies are likely to face stiff political opposition.
Improvements in productivity could mitigate the impact of higher wages on inflation. However, recent trends do not give grounds for optimism on this front, and efficiency improvements are likely to prove more difficult in advanced economies dominated by the services sector, which is generally more labour intensive and is only likely to grow in significance over time.
“Deglobalisation”
Another development often cited as potentially driving inflation higher over the longer term is that of a reversal of the process of globalization – i.e., the increase in flows of traded goods, services, people, investment and technology across national borders – that was evident during much of the last century. The impact of globalization on inflation is complex and multi-faceted. However, there is general agreement that the integration of low wage economies into global value chains, exemplified by the sharp rise in the share of merchandise trade in GDP between the mid-1990s and the mid-2000s8, has served to bear down on inflation in advanced economies.
Globalisation has impacted inflation in advanced economies via several channels. Cheap imported goods have had a direct impact on prices, but have also created a more competitive environment for domestic producers, making it more difficult to raise prices without losing market share. Cheap imports, migrant workers, and the threat of companies potentially moving production overseas have also weakened the bargaining power of workers in advanced economies, thereby keeping a lid on domestic labour costs.
There is some evidence to suggest that globalisation is going into reverse. As a share of GDP, both global merchandise trade and foreign direct investment peaked in 2007-08 and have since fallen back9. In part, this reflects an increase in protectionist measures introduced in the wake of the Great Financial Crisis10 and deteriorating relations between the US and China. President Joe Biden has kept in place the tariffs on Chinese goods introduced by his predecessor, Donald Trump, and, amidst rising national security concerns, has imposed stiff export controls on US high-tech equipment to China.
In addition, following the widespread disruption during the pandemic, there has been a push to make global supply chains more resilient, even if this comes at the expense of reduced efficiency. One survey conducted in 2022 found that more than 60% of European and US manufacturing companies expect to onshore or re-shore part of their Asian production during the following three years11. Although technological developments might soften the impact, the process of making global supply chains more robust is likely to be associated with increased costs (e.g. more spare capacity, higher inventories etc.) which could potentially push up prices.
Political developments (e.g., Brexit in the UK, the European embargo of Russian oil exports, and a more general inclination towards increased ‘self-sufficiency’ in strategically important areas) also point to a move away from cost minimisation as the primary driver of how goods and services are sourced.
Green transition
The move towards more environmentally sustainable means of consumption and production is also likely to increase input costs for companies. As noted in our commentary of February 2022, capital expenditure in conventional energy production has fallen in recent years as the focus has turned to net-zero carbon emissions targets12. As a result, a lack of spare capacity threatens to keep oil and gas prices elevated, while increased use of carbon pricing mechanisms are also likely to increase costs in energy-intensive industries. The transition to alternative energy sources (wind, solar etc.) is also likely to put upward pressure on prices for commodities, particularly those such as lithium (used in batteries) and copper (used for electrification) which face supply shortages.
Structural shift?
What does all this mean for the longer-term inflation outlook? With price increases set to ease this year, it would not be a surprise if we start to hear renewed talk of recent above-target inflation as being ‘transitory’. The impact from certain extreme moves in prices (e.g., container shipping costs, used car prices) might legitimately be described in this way. Even so, we should not ignore the longer-term, slow-moving changes in the global economy that threaten to undermine the conditions that facilitated the period of low and stable inflation that has characterised recent decades.
It is open to debate whether some of these developments represent one-off changes in relative prices or a more generalised inflationary impulse. Furthermore, the extent to which increased costs result in higher inflation will depend on the degree to which corporations are able to pass on such increases to the end consumer.
However, the concurrence of the three trends identified in this article – ageing populations, ‘deglobalization’ and the green transition – could mean that once the extreme inflation volatility associated directly with the pandemic and the war in Ukraine dissipates, we are then faced with a period of structurally higher inflation, which makes it more difficult for central banks to achieve their 2% inflation targets.
The question then arises as to whether policymakers will have the fortitude to keep monetary policy tight enough to keep inflation in check. Raising interest rates at a time of historically low unemployment has been relatively easy; keeping policy restrictive once jobless totals start to rise and debt servicing costs become increasingly burdensome will be more difficult.
14th February 2023
1 https://www.federalreserve.gov/newsevents/speech/powell20221130a.htm
2 https://www.epi.org/blog/corporate-profits-have-contributed-disproportionately-to-inflation-how-should-policymakers-respond/
3 https://www.atlantafed.org/chcs/wage-growth-tracker
4 https://www.ons.gov.uk/employmentandlabourmarket/peopleinwork/employmentandemployeetypes/bulletins/uklabourmarket/february2023
5 https://covid19.who.int/
6 https://www.businessinsider.com/labor-shortages-immigration-retirement-covid-2022-12?r=US&IR=T
7 https://www.bis.org/publ/work722.htm
8 https://data.worldbank.org/indicator/TG.VAL.TOTL.GD.ZS
9 https://data.worldbank.org/indicator/BX.KLT.DINV.WD.GD.ZS
10 https://www.globaltradealert.org/global_dynamics/day-to_0213/flow_all
11 https://bciglobal.com/en/reshoring-production-back-to-europe-and-the-us-is-on-the-rise-particularly-for-critical-parts-and-final-production-processes
12 https://www.afhwm.co.uk/resources/commentaries/economic-commentary-how-might-climate-change-affect-inflation