Why inflation is likely to stick around

Today I am not going to lay out any data or anything like that. I jut want to put down some thoughts on inflation. I will do so in the form of a Q&A as it will allow for a Devil’s Advocate sort of assessment. This is important because I think there are reasonable disagreements over whether inflation is here to stay or not.

What caused the inflation?

In my view the inflation started due to the lockdown policies. Personally, I expected the inflation to start much sooner and was surprised that when everyone was working from home there was no price pressure. This appears to have been because developed economies have a lot of in-built redundancy and we were able to coast on this for a while. But eventually the piper demanded to be paid and prices started to rise. This was due to the collapse of various parts of the supply chain but there are also likely to be medium and long-term issues due to a rot that has set in to the supply chain — more on this later.

The war in Ukraine added a huge amount of fuel to the inflationary fire. The most obvious impacts are via the energy markets, but markets for various components required in the production process — like fertiliser and rare metals — have also been impacted.

Will energy prices come down and will this end the inflation?

They may. There are three ways that they might settle down. (1) A recession may suppress demand for energy. (2) Supply and demand could reshuffle the markets in such a way that prices fall. (3) The war in Ukraine might end and the sanctions on Russia could be withdrawn. Let’s assess the likelihood of each.

(1) A recession seems to me the most credible way for energy prices to come down. But it is not guaranteed. We saw inflations in the 1970s that did not lead to energy prices falling.

(2) The high energy prices should certainly lead to new fields being activated. But it is likely that these fields are only viable at high prices and for this reason the dent they will put in prices will be modest. It is best to think of the present crisis as a massive supply shock to the energy markets. Russian oil, for example, is flowing to other countries at ‘normal’ prices and we are left with less oil to go around in the West.

(3) I believe that this will happen eventually. But it could take a long time. The war is likely to last until the end of the year at least. Meanwhile, policies like sanctions (and lockdowns!) are easy to put in place and very hard to remove. Politicians are going to have a very hard time undoing what they have done.

If the energy prices come down would it end the inflation? Probably not. It would certainly temper it, but the problems are not confined to energy markets.

Have the effects from lockdowns passed?

I don’t think they have. As I alluded to earlier, I think there is evidence of rot in the supply chain. We have reports, for example, of a disproportionate number of industrial accidents in the US that are leading to factories shutting down. I think the most likely explanation of this is that maintanence was not undertaken during the lockdown and this has led to factories that are rotten and fragile.

I also believe that work-from-home leads to far lower productivity and hence in a smaller overall supply-side. Work-from-home has partly reverted to normal — certainly offices have made a comeback — but I think that comeback has only been partial. I think that work-from-home will eventually be scrapped as a failed experiment but that could take a long time. It would require management in various companies to take an assertive role, something it has notably not been doing these past few years. Not to put too fine a point on it, but it increasingly feels like we are living in a world where no one is really in charge anymore.

Would an end to the war and a lifting of sanctions allow supply chains to fully revert to normal?

Again, I think probably not. The war is about more than just the war. It appears that China and Russia are trying to repolarise the world in such a way that these two countries, together with the others BRICS (and a few others), will stop relying so much on the Western economies for their growth and prosperity. Until now these countries have provided us with effective cheap labour and limitless raw materials. When this labour gets more expensive, prices will rise. And as these economies focus more on developing their own resources into production and consumption goods instead of sending them to us, prices will rise.

Then there is the question of currencies. I expect that the global financial system will alter drastically in the coming decade. The US dollar will be partly replaced by other currencies and financial centers like London will become less important. This should put secular downward pressure on these currencies and this will contribute to a ‘slowburn’ rise in the cost of living that manifests as inflation that outpaces real wage growth.

There is some discussion of demographic problems leading to rising prices. Do you concur with this assessment?

At some point the aging population will have to mean rising prices. As the number of retirees rises relative to the number of producers there will simply be less stuff to go around. Automation and so on should be able to ease the pressure somewhat, but not fully. So, I do think that this will create more inflationary pressures. However, I do not expect this problem to really ‘bite’ until the millenials reach retirement.

It seems that you don’t think this is a normal inflation, do you?

Increasingly, I do not. I get the sense more and more that what we are watching is a serious decline in living standards in the Western world. We have been living on borrowed time for years, relying on our financial systems to prop up our large trade deficits. In recent times we have become particularly complacent, seemingly believing that we can restructure our economies in radical ways without any impact on living standards.

Since the COVID-19 outbreak there has also been a tendency for our political leaders to undertake extreme and mostly arbitrary interventions into our economies. Economists pointing out how dangerous this is are clearly in short supply. Those who do speak about it are not really listened to. Until recently there was a taboo in place about too much intervention in the economy that was prevalent amongst the political class. This taboo has collapsed completely and now the economy seems to be a considered only secondarily.

So, we have a perfect storm. The bill is coming due on decades of easy living. At the same time, we have leaders who have forgotten how important maintaining a stable and growing economy is. This seems to me a recipe for disaster.