Han Dieperink: Inflation will first be lower, then higher
This column was originally written in Dutch. This is an English translation.
By Han Dieperink, written in a personal capacity
The development of inflation is difficult to predict. A wide range of scenarios is possible and, moreover, short- and long-term expectations can differ greatly. For the time being, it appears that inflation will decrease in the short term and increase again in the long term.
All major indicators point towards disinflation for the rest of the year. The bond market is usually smarter than many forecasters in that respect. In 2022, when everyone feared inflation or even hyperinflation, the bond market already anticipated that inflation would be a temporary phenomenon.
Inflation came in three waves this time. The first wave followed government intervention in response to the covid crisis, which was largely the result of collective fear fueled by social media. Part of that intervention was that the government injected a lot of liquidity into the economy, which seemed similar to the large injections following the Great Financial Crisis. These did not cause inflation, because all that liquidity was used to plug the holes in the financial system. Now suddenly 30% more liquidity went to the real economy.
At the same time, consumers had to stay at home and could not go on holiday. As many as three-quarters of unemployed people in the United States received more money from the government than when they were working. So as they couldn't go to the pub or on holiday, they could only buy things. These things are now made in China and, not coincidentally, exports there increased by 30% in a short time.
It is strange that not all containers were in the right place. This inflation is now behind us. Post-covid there was even deflation in goods, but that has also almost leveled off, although China is still exporting deflation.
The second wave of inflation was caused by the Russian invasion of Ukraine. This was especially noticeable in energy prices and food prices. Now in fact everything consists of energy, so that development also had important second round effects. Food prices – which consist of 70% energy – also rose sharply. Wars by definition cause more inflation, but the global economy managed to adapt quite quickly. Europe had to quickly get rid of Russian natural gas, but is partly importing it again in liquid form (LNG) from other countries. On balance, there are still enough holes in the Russian boycott that this inflation is also much less of a problem.
The third wave of inflation comes from companies that were able to increase their prices as a result of the previously increased inflation. Even if costs did not or barely increase, just about every company gained more pricing power. Entrepreneurs could refer to the covid crisis or the Russian invasion, or else to the fact that prices rose sharply everywhere. This is also called grabflation. That is unjustified, as a company that cannot pass on increased costs will not have a long life.
At this point, inflation has largely normalized. Most prices are even falling again, although they will remain high for longer in segments where there was already a shortage (the housing market). Ultimately, competition in a free market causes prices to fall, the natural state of capitalism.
So central bankers were initially correct in stating that inflation would be a temporary phenomenon. However, they succumbed to pressure from social media by taking drastic action at a certain point. Because they implicitly recognized that they were wrong, they are now keeping interest rates high for longer. Strangely enough, central bankers tend to focus mainly on inflation and unemployment, two lagging indicators, while figures that can say something about future inflation point to disinflation in the second half of the year.
The recent upturn in inflation in the first three months of this year caused a commotion and gave reason to think that inflation would remain high for longer and would not fall below 2% so quickly. Now that is not so bad for central bankers. The mountain of government debt has risen sharply and reflation or financial repression is a solution rather than a problem.
Now, during the publication of those inflation figures last month, it became clear that setbacks were mainly the result of incidental factors. In the vast majority of the inflation basket, prices simply fell. Once again, the bond market is still the best indicator of future inflation. However, in the longer term there are sufficient indicators for a structurally higher inflation level:
- Deglobalization ensures that more is produced locally. The main reason for producing far away was a low cost price. Producing nearby is more expensive, although there are also advantages, such as fewer inventories, being able to respond better to consumer preferences and more flexibility in general. Moreover, costs can be reduced by replacing people with machines (robots).
- Due to an aging population, fewer people will produce, but more people will consume. The difference with the past is that these post-war retirees are the first generation to have fully saved for retirement. For years they worked up to one and a half days a week for that pension. This postponed consumption will follow in the coming years.
- Companies operate less and less in a free market. When there is sufficient competition, prices can only go one way and that is down. In the natural state of capitalism there is deflation. Innovation ensures that companies become more productive and can therefore offer their products more cheaply. But in an oligopoly or a monopoly there are no incentives to compete on price and there is also less innovation.
- Nowadays the government is ready with a big bag of money for every problem of the citizen. Elections are not won by raising taxes and cutting subsidies. Now socialists are very adept at spending money they have not earned themselves, but many populists have an even more extreme left-wing agenda from an economic point of view. The political discussion about social security is relatively new. As a result, the minimum wage has already risen sharply in several countries in a short time. The capital-labor pendulum is clearly swinging towards the labor factor and this may eventually lead to a wage-price spiral.
- Wars are expensive and the response to the war in Ukraine has been heavy rearmament in several countries. During wars there is also a high demand for raw materials. Wars cause rising budget deficits.
- The energy transition. There are plenty of investments in alternative forms of energy, although it will take some time before alternative energy is available on a comparable scale to energy from fossil fuels. The result is that significant investments are also needed in infrastructure. Not only in the field of electricity, but also in infrastructure built immediately after the Second World War.
- Investments in artificial intelligence are high and will have to be recouped by companies that have a virtual monopoly position. Companies like Microsoft, Google, Amazon and Meta. In addition, artificial intelligence creates an additional demand for energy. Of course, all these investments also come with efficiency benefits, but these companies are very much able to pass on higher costs to the customer.
- Emerging markets are gaining increasing weight in the global economy. In addition to China, India now also contributes more to the growth of the world economy than the United States. This means that inflation figures are becoming increasingly important in these countries. At the moment, China is still exporting deflation, but if the rebalancing of the Chinese economy is successful, the fun will be over in some time.
Conclusion
Inflation may remain low in the longer term if the market continues to believe that central banks will do everything they can to keep it low. In that respect, inflation is always and everywhere a monetary phenomenon. Central bankers have now even managed to reduce inflation without a recession. That is a major achievement.
At the same time, monetary authorities cannot ignore the mountain of debt. Only they can solve it painlessly without democratic discussion through reflation and financial repression. By keeping short- and long-term interest rates structurally below the nominal growth rate of the economy, debts (as a percentage of that economy, GDP) ultimately decrease. Central bankers will not budge on an inflation standard of 2%, but they may work with (implicitly) larger bandwidths around that 2%.