Transitory or not, the Great Inflation Debate is really missing the point…

With the most recent economic data that paints an emergent picture of a fast-cooling global economy, a collective and audible sigh of relief could almost be heard from economists the world over. Or rather those who had always claimed that inflation was transitory and the result of momentary supply-side bottlenecks, caused by a pandemic and the Russia-Ukraine war. 

With markets now more preoccupied with concerns over a coming global recession, commodity prices, very much the trigger and main driver for inflation today, have fallen dramatically last few weeks. From copper, a keenly-observed benchmark for the fate of the global economy as a whole that fell by over 20% since May, to oil that is almost back to pre-Ukraine war levels to even wheat that has fallen over 40% since end-June with much of the world’s supply still stuck in Ukraine because of a Russian blockade in the Black Sea. It seems inflation might be a passing phase and those same economists who were so wrong not long ago, might be right after all (if not a year late with their predictions).

Notable amongst them is 2008 Nobel Prize winner, Paul Krugman.  Citing the well-regarded St Louis Fed Reserve inflation indicator that forecasts inflation 5 years ahead in U.S, and that has dropped sharply from a high of 3.34% in August last year, he tweeted:

“5 year breakeven at 2.48.  Out of control inflation expectations my…asset.”

Krugman couldn’t resist a dig at the opposing “inflationistas” as they are known in (geek) economists circles, lead by the likes of Larry Summers, former US Secretary of the Treasury who had long-predicted the dawn of persistently high inflation as far back as the ’08 GFC.

“stagflation narrative is really collapsing,”  Krugman argued, and taking aim at the opposing camp he tweeted, “waiting years for the chance to posture sternly against runaway inflation, and really, really won’t want to back down.”

These vertiginous slides have lead to the likes of Albert Edwards, co-head of global strategy at Société Générale, a French multinational investment bank, to even posit that we may be about to enter a deflationary period in the next six months. 

While such predictions might come true, to be frank, the short-term picture is still murky. As even Edwards admits, the jury is definitely still out whatever the likes of Krugman would have us believe.  Commodity prices might have only taken a temporary hit for example as a result of a lull in the war in Ukraine as both sides take a moment to replenish depleted ammunition and morale and normal market movements, and could well begin to rise again in autumn.  Certainly, with a complete shut-off of Russian gas on the horizon for Europe in the coming months, and the war heating up once more, a price rise is definitely not out of the question.

And it is not just commodity prices.  A lot of other economic indicators clearly show that inflation has spread to other parts of the world economy and might be a lot more ingrained than previously thought.  The real worry is that expectations of future inflation will drive up wages in an already over-heated labour market close to full employment, that in turn forces companies to raise prices on consumer goods and services to pay for those same wage increases and that in turn causes another bout of wage inflation and so on and so forth.  To back this up, the most recent employment figures in the U.S for non-farm payroll in June defied expectations, where 372,000 jobs were added and that was way above the 265,000 predicted.  A labour market with a historically low unemployment rate of 3.6% could easily fan the flames and drive systemic inflation that outweighs any fall – momentary or not – in commodity prices.

But all this is really, really missing the point. 

Whether inflation is transitory right now or not, one thing is for sure:

It is a sign of things to come.

It is a sign of a high-inflation and possibly stagflationary world that will be hard to contain later in the decade.  The clue as to why can be found in a simple innocuous-looking sentence at the end of a recent UNCTAD summary looking at the record global trade levels today ( https://unctad.org/news/global-trade-hits-record-77-trillion-first-quarter-2022 )

“Other factors expected to influence global trade this year are continuing challenges for global supply chains, regionalization trends and policies supporting the transition towards a greener global economy.”

To understand why the future path for inflation, and therefore the wider global economy might be bleak, one needs to first understand why there was a low-inflation environment in the immediate pre-pandemic era and as far back as the ’08 GFC (Global Financial Crisis) that seemed to defy classical economic theory.   In the face of historically low interest rates and sizeable QE (central bank “quantative easing” programmes of buying up assets with newly created reserves, thereby increasing the money supply) and a red-hot labour market later on in the 2010s, inflation hardly budged from is low slumber. In the U.S it averaged around 1.8% during the last decade.  Under such conditions, inflation, as conventional wisdom goes, should have been rampant but wasn’t. 

The answer it turns out could be whittled down to one word:

China

If research reports from the likes of the well-respected NBER (National Bureau of Economic Research), a non-partisan NPO and the IMF is to be believed, then the main reason for the low-inflation puzzle was nearly all down to cheap manufactured goods coming out of China.  NBER was able to show that in the service industry by contrast, inflation averaged closer to 10% in OECD countries in the last decade, as most services are domestic and largely not globalised (to ask a rhetorical question, how many people in the west go to multinational Chinese supermarkets or banks?).

With supply chain resilience rather than efficiency currently becoming increasingly important, repatriating supply lines, nearshoring, and so-called “friend-shoring”, that is moving supply chains to politically-friendly and stable countries that are more closely aligned to western ideas on democracy and human rights, is all the rage. 

If goods manufacture were to move en masse away from China and were repatriated back to OECD countries for example, then the argument goes that it would reintroduce inflationary pressures on countries that would become more sensitive to traditional economics, like the good old days of boom and bust in the 70s, 80s and 90s.

Indeed, moving supply chains away from China had been slowly gathering pace even before the pandemic and the war in Ukraine.  And it was not just driven by geopolitical and human rights considerations, but rather by automation, that makes advantages in low-cost labour increasingly redundant when considering supply chain efficiency.  This was coupled with the fact that wages in China had been steadily rising anyway, eating away at this particular comparative advantage.

But while global trade – as a percentage of GDP – has been falling slowly but surely, to say that there has been a dramatic shift away from China right now would be an overstatement to say the least.  In fact, a closer look at the figures paints a far more complex picture.  One where U.S agricultural exports to China shot up by more than double between 2020 and 2021 from US$17 billion to over US$36 billion.  And one where Chinese companies seem to be moving their own production to East Asia to avoid U.S tariffs and general scrutiny and even (although largely inchoate) moving them to Mexico to take advantage of the free trade agreement between Mexico, U.S and Canada.  And also where out of 300 U.S companies in China itself, 60% have stated they have increased their investment compared to 2020.  Even Apple that relocated a substantial portion of its manufacturing to Vietnam and away from China, still sells 40% of its total final products back to China according to Business Insider.

The overall trend worldwide – whatever the excited chatter in media, academic circles and even boardrooms might be – has not been to re-shore, friend-shore or even nearshore, of which there is little evidence. But rather it has been to diversify supply lines and build up inventories (a build-up amounting to 1% of global GDP by the world’s largest 3000 companies since 2019 according to analysis conducted by the Economist magazine). For all their talk, across OECD countries, manufacturing as a share of GDP still makes up only 13% of thr total – an all-time low.

So does this then mean business as usual once the current crisis passes? Back to the low-inflation environment and a flood of cheap goods from China?

Not so fast.

A deeper examination and the trend is definitely trending slowly but surely towards huge changes and coming upheaval in supply chains, even if they haven’t been realised already.  What diversification of supply lines and the building up of inventories actually points to is a proverbial “wait and see” policy for many multinationals, rather than undertake the intense trauma of supply line relocation until completely necessary.  But plans afoot all seem to point to coming change.

New Foreign Direct Investment (or “greenfield FDI”, meaning completely new investment and not such things as M&A, mergers and acquisitions, for example) in China has fallen dramatically.  In the mid-2000s, 20% of all new investment was going towards China. That figure is now only 5%.

Whereas not a single OECD country was a net dis-investor in China not 8 years ago, now at least 1/5 of all rich countries are mostly disinvesting in the country. 

And while trends seem to be creeping away from China, one issue looms over all.  One that might turn a trickle into a raging torrent:

And that of course is Taiwan.

If the trauma of economic disassociation with Russia following the invasion in February appeared traumatic, this will be nothing compared to the upheaval that a confrontation over Taiwan will trigger.  Most analysts still underestimate the re-introduction of geopolitics into their forecasts, not seen on this scale since the Cold War and the disruption it can cause.  Increasingly the overriding factors now are no longer just economic.  Since in fact Brexit and Trump in 2016, they have become more and more political and will continue to do so.  A return to the 1990s where simple efficiency considerations were all that was required when planning global supply lines does not seem imminent. 

But when all is said and done, what will mostly drive a wave of nearshoring and even re-shoring for most companies will still be the profit motive over the long-term, even in the face of geopolitical shocks to the system.  And even here there are whispers from around the world of near and re-shoring success stories.  Where a drive towards more resilient supply lines may also be the most efficient in some cases.  In the car industry for example, vertical integration, where the company controls all elements of its supply lines, from the mines for raw materials, to manufacture, to even the car showrooms has been driven largely by the success of Tesla. 

Even in the country where I reside in South Africa, there has been a notable success story in the clothing industry in The Foschini Group (TFG).  The company has defied all expectations and recorded market-leading net revenues by repatriating most of its production from places such as China, Bangladesh and Myanmar.  Using modern technology, TFG was able to make its production more sensitive to domestic demand by using latest digital tech and ultimately by bringing production closer to home.  A dying or dead industry once said to have been destroyed by China seems to be more than alive and well at this moment and will likely drive TFG’s competitors to do the same.

What such glimpses of success worldwide show is that nearshoring and even repatriating supply lines doesn’t necessarily always mean an inability to compete.

But ultimately n the long-run, even if it does bring higher net revenues for some multinationals, this trend can only cause higher inflation – or rather inflation more sensitive to each country’s domestic macroeconomic situation.  For example, TFG might be able to be more efficient, but if energy costs shot up in South Africa, or the rand was devalued, all factors completely outside its control, then it doesn’t matter how efficient its production line are, prices will probably go up.

But of far more significance for inflation will be over-zealous government intervention.  As success stories such as Tesla and TFG multiply, governments around the world will not be able to resist the temptation of jumping on the bandwagon.  They will try and aid entire industries within their domestic economies in an attempt to bring back meaningful production and crucially, jobs.  The ultimate goal being to reverse the decline of their respective middle classes and the source of so much upheaval in rich-world politics at the moment. 

To assist in repatriating supply lines, many governments have reintroduced once unfashionable industrial policies.  From funding R&D to protecting “strategic” sectors, that since the pandemic are not limited to defence and computer tech but have vastly broadened in scope, industrial policy is making a comeback with a zeal.  A remarkable fact is that over 200 countries representing over 90% of GDP now have some form of industrial policy, and the main thrust has been since 2019.

As great as protecting and nurturing domestic industries might seem, governments historically have not had a good record at its success.  To say the least.  Apart from their past failures though not boding well for the future, the real problem right now is that most countries are all focused on the same list of industries, namely A.I, clean energy, semiconductors and quantum computing.  This will almost definitely lead to large inefficiencies, and in the medium-term will lead to higher input prices and consequently higher inflation. 

The coming energy upheaval: If you thought higher oil and gas prices after the Russian invasion of Ukraine were bad. You ain’t seen nothing yet…

Add to all that, is the coming upheaval in energy markets, the lifeblood of world economies. 

Put simply and brutally, the transition to greener energy sources has been left way too late and will be tumultuous to introduce yet another understatement to proceedings.

There is a great article written recently by Ted Nordhaus in Foreign Policy magazine that is far more comprehensive in its scope and a must-read for those interested in how the Russia-Ukraine war has impacted our collective drive towards greener economies: “Russia’s War Is the End of Climate Policy as We Know It.”  ( https://foreignpolicy.com/2022/06/05/climate-policy-ukraine-russia-energy-security-emissions-cold-war-fossil-fuels/ )

In it, Nordhaus veers towards the positive and argues that a renewed focus on energy security that has been thrust back into the limelight by a “fossil fuel superpower gone rogue in Eastern Europe” might do more to focus minds and transform our economies to greener energy sources than unrealistic and idealistic hubris by the climate movement ever could before it. 

But, there is also enough alarming evidence to point to the opposite occurring; Where current geopolitical turbulence has already seen many countries recoil from their net-zero obligations.  They might all plead that it is temporary, but in the current crisis, where, by all accounts we are in urgent need of a dramatic and immediate reduction in carbon. Any pause, however momentary, will push us all closer to that ultimate tipping point of 2C above pre-industrial levels sooner rather than later.  As this happens, it will just lead to ever more geopolitical turmoil in an unholy cycle downwards.  Germany for example right now is attempting to pre-empt Russia from cutting off the gas taps completely by restarting a fifth of all its coal-powered plants that were recently shut down.  And there are murmurs amongst usually environmentally-ardent Democrats in the U.S to ease opposition to the infamous Keystone Oil Pipeline from Canada. 

All the turmoil will lead to ever more unstable and therefore sustained higher energy prices.  In the long-term, the underlying trend too is towards disinvestment from the sector that will just add to the inflationary pressures in energy.  As even Nordhaus admits, “most of the low-cost, easily accessible oil and gas fields have been developed, while new production is costlier to reach and harder to extract.”   The renewed focus on the Trans-Saharan gas pipeline that will bring gas in from Nigeria to Morocco and then onto the European market for example, shows a trend towards increasing reliance on unstable sources that will ultimately only bring more mayhem and higher prices in the long-run. 

Adding fuel to the proverbial fire is the ever-more effective disinvestment lobby whose campaigns target bank funding and insurance company backing of oil and gas infrastructural projects.  The increasing success of such campaigns is best exemplified by the current one against the East African Crude Oil Pipeline started by BankTrack in 2018, an NGO that campaigns against dubious private commercial bank activities. Noble and essential as these campaigns are, nevertheless the simple truth is they will supercharge energy inflation as they become more widespread.

All in all, in the medium-term both higher energy costs due to upheaval in the energy sector and fundamental changes in supply chains that are only now coming to fruition and likely to accelerate later in the decade, will lead to higher inflation.  Something that the current upheaval is but a taste of.  And as the IMF recently pointed out, the effects of even just technological “economic geofragmentation” as they likje to refer to it, will be about 5% for many countries – both rich and poor. 

With all this in front of us, it is hard to see any other conclusion than higher inflation and possibly negative growth rates that will give us a world of structural stagflation coupled with ever-increasing geopolitical upheaval.