Inflation... where do we go from here?

Inflation hangs over the world like a dark shadow, threatening to eat away at profits and wages and undermine markets. What could be causing it and how could it shape our economies?

It wasn’t so long ago that economists were predicting a 21st-century version of the Roaring Twenties. Equity markets were robust, low inflation rates had stabilized the world’s economic engines, and high-tech was promising a new era of productivity.

Then, in the short span of a couple years, one black swan after another flew over the horizon: The first pandemic in a century, the first major European war in 75 years, and the worst inflation in 40 years. With all of these sudden, game-changing events – not to mention global climate change – the current decade appears to be shaping up as the Turbulent Twenties.

Such is the nature of black swans that we may not have seen the last of them. As of this writing in early August, the World Health Organization has declared monkeypox a global emergency, and by some accounts, China may be planning a military operation to overrun Taiwan within the next 18 months.

How economies will fare going forward is an open question. Some observers believe that prices have already peaked and that inflation will be manageable in a few months. Others, including StoneX Financial Inc. economist Vincent Deluard, Director of Global Macro Strategy, assert that structural forces may keep inflation at an elevated level for years.

In the next few pages, we examine the current bout of inflation and how it has shown up in various markets. We also take a look at plausible outcomes in the near and long term.

Where did it start?

In July, the US Consumer Price Index (CPI) hit a 40-year high of 9.1%. Europe, which calculates its inflation rate slightly differently, also saw prices rise at a similar pace, as did countries around the world, including those with both advanced and developing economies.

Source: Haver Analytics; IMF, Global Data Source; and IMF staff calculations.
Note: AUS not reported. SAU core inflation is not reported due to data limitations. ZAF and IDN target reflects the mid-point of the target range. EU: no inflation target available as monetary policy is set at the euro area or individual country level.

The fact that so many countries are struggling with rising prices shouldn’t be surprising. Most major markets are indeed global, and when petrol is costly in Lima, Peru, it’s also costly in Lima, Ohio. Moreover, this particular bout of inflation had a worldwide genesis – the Covid pandemic.

As the virus spread, massive lockdowns and layoffs sent world GDP tumbling at a rate of -3.27% compared to the year before, depressing overall GDP by nearly 6%. The resulting drop in prices created a much lower base from which inflation would be calculated going forward, the so-called “base effect.”

The pandemic also put the world’s economies, and the societies they supported, at great risk. As a form of life support, governments injected an unprecedented amount of stimulus into their economies, either through direct payments to citizens, as in the US, or via subsidies and loans to corporations, the policy favored in Europe. The stimulus funds kept economies and societies afloat, but they also provided a huge bump in consumer purchasing power.

Much of this added purchasing power was used by homebound workers to buy goods online and make up for the services they could no longer consume, such as dining out and travel. The sudden increase in demand, coupled with a supply chain that was struggling from shutdowns, put upward pressure on prices, especially during the post- pandemic recovery in 2021 and 2022.

Then last February, the effects of the Russia’s invasion of Ukraine sent the price of oil soaring to over $120 per barrel, giving inflation a dramatic boost.

The fallout of all of these forces is still very much with us. For example, car manufacturing continues to be hampered by a shortage of computer chips, which GM cited as the reason it sent 95,000 fewer vehicles to dealers in the second quarter. As fewer vehicles are produced, prices of available cars, including used ones, remain high.

Everything is connected

Although inflation is nearly universal, it varies widely among markets. So while the price tags on luxury goods and real estate have been off the charts, televisions and smart phones can be had at a bargain. In the US, retailers discounted 71% of the TVs sold between January and April, compared to only 18% the year before. Smart phones also saw heavy discounts during the same period.

One reason for this variance is that markets could continue to be driven by their own internal conditions. Energy supplies, for instance, faced headwinds even before inflation hit. US shale oil fields were struggling to restore production to meet greater post- pandemic demand, and the Biden Administration’s push toward clean energy made investors reluctant to finance new fossil fuel production. Meanwhile, OPEC and affiliated producer countries also had difficulties bringing wells back online to meet growing demand.

Prices for food-based commodities have also reflected structural problems. Global stocks of corn and wheat have been trending lower over the past 50 years as manufacturers, wholesalers and retailers became increasingly comfortable with “just- in-time” deliveries. The system was strained, however, when back-to-back years of adverse weather constricted supplies. Then the Russian invasion of Ukraine made the situation considerably worse. Both countries are major exporters of wheat, but because Russia has prevented the lion’s share of Ukraine’s harvest from leaving its shores, the price of wheat spiked by 34% in mid-summer, according to the World Bank.

Despite these differences within markets, there is no getting away from their interconnectedness. Over the past year, dairy products shot up by 13.5% in the US, likely due to lower milk production. Some observers blame the price spike on the higher cost of transportation, which may have prompted farmers to slaughter their cows rather than ship them to dairies, shrinking the US herd by 100,000 head compared to the previous year.

Industrial metals and market dynamics

Price Movement

Source: Bloomberg

Central banks’ approach to inflation

US Federal Reserve Chairman Jerome Powell has asserted that the Fed is “strongly committed” to bringing inflation back down to a manageable level, which the Fed has set at 2%. To get there, the Fed has made a number of rate hikes that, according to their projections this summer, will top out around 3.5% by year-end. Other central banks, such as the Bank of Canada and the European Central Bank, have bumped up interest rates as well. But the overriding question is whether their approach will work.

Vincent Deluard, StoneX Financial Inc.’s Director of Global Macro Strategy, says the answer is probably not. In a June newsletter, Deluard wrote, “According to the World Bank, inflation spiked above 7% 352 times and central bankers were able to restore full price stability in just 1.4% of these instances.”

What concerns Deluard is that an inflationary mindset tends to become entrenched.

“High inflation begets more inflation as agents start to incorporate higher prices into their behaviors,” he wrote. “Consumers front-run their purchases to avoid paying more later. Creditors bill their clients faster. Workers bargain for pre-emptive wage increases.”

To have a statistically reasonable chance of quelling inflation in the short term, Deluard said in a recent video, central bankers must impose lending rates that are higher than the current rate of inflation. That is to say, positive “real rates,” as economists refer to them.

The fear, of course, is that such a hike would pitch economies into a deep recession, as it did in the US in the late 1970s. Arlan Suderman, StoneX Financial Inc.’s Chief Commodities Economist, also believes that much stronger medicine is needed. “Bringing inflation under control means withdrawing the stimulus still in the economy fueling the demand for goods,” he noted. “Controlling inflation also means bringing wage inflation under control, and that may necessitate pushing the unemployment rate higher to bring labor supply and demand into better balance.”

And there is no better time to do that than now, according to Josh Cannington, StoneX Markets LLC’s Vice President - Interest Rates Derivatives, “The only crutch the Fed can lean on at this point is this historically strong labor market,” Cannington said. “The unemployment rate is near record lows, nominal wages are rising, and there are 1.9 job-openings for every unemployed worker. Even if we begin to see a deterioration in the labor market, there is enough room there to give the Fed some creative liberties to continue raising policy rates until inflation shows a convincing downward trend.” Matthew Simpson, Market Analyst at StoneX Financial Pty Ltd., takes a slightly softer approach. “I’m now in the camp that inflation will be tamed (eventually), but no thanks to the slow policy response from central banks.” Still, he worries that the measures being taken won’t be enough. “If inflation remains elevated – or ‘sticky’ at higher levels – it may simply prolong the pain for business and consumers. And that means weaker growth with a slower, grizzly bear market.”

THE LONG VIEW: Demographic and Economic Trends

But what if inflation does remain elevated and is with us for many years? According to Deluard, that is the more likely scenario, and though it will be a tough pill to swallow, in the long run, it will actually be good medicine for the world’s economies.

He bases his prognosis on a number of demographic and economic trends that are shaping the 21st century. One such trend is what he calls The Great Demographic Squeeze. In this major shift, an aging population is far outpacing the number of young and healthy workers who can support them in retirement. This is happening not only in the West, but in countries around the world. In China, for instance, 10 million workers are retiring every year without being replaced by younger workers.

In the US, the ratio of young, healthy workers to inactive workers rose from 1:1 to 1:4.4 in the past 40 years.

U.S. Population by Age Group

Source: Bloomberg

The lack of workers can’t help but be inflationary “unless a productivity miracle happens,” Deluard wrote. But the prospect of any such miracle, he noted, was dispelled by the VC bubble in high-tech that recently went bust. Even successful high-tech firms that were once celebrated as game-changers have fallen short of their promise to increase productivity and reduce costs.

Among other examples, Deluard cited Airbnb, which was founded on the idea of providing lower-cost vacation rentals through the efficient matching of property owners and sojourners via the Internet. But now that Airbnb dominates the cyber-rental market, its listed rates are the same as hotels in many hot spots, such as Miami.

Airbnb versus Miami Beach Hotels

Another major structural trend will be driven by the demographic changes in China, according to Deluard. Because it had fewer workers to run its factories, after 2010, China subsidized housing construction on a massive scale in order to maintain economic growth. Now with an oversupply of real estate, the only way China can continue to grow at a healthy pace (and thereby quell unrest) could be to increase the portion of its GDP that comes from consumption. Today, consumption accounts for only 55% of China’s GDP, compared to around 80% in the US.

As China transitions from an export economy to a consumer economy, it is in the country’s interest to maintain a strong currency rather than an artificially weak one, such as it did to bolster exports. Like other consumer economies in the West, China will want its citizens to pay market-clearing prices for goods and earn high wages that enable discretionary spending.

In practical terms, that means that China, and by imitation, the rest of East Asia, will no longer act as a price sponge for the ever-rising demand of others. Instead of essentially exporting deflation, the region will export inflation in the form of more expensive goods and services.

Generational rebalancing and economic health

If all of this sounds foreboding, there is a silver lining, according to Deluard. Although the current bout of inflation was triggered by the pandemic and the response to it, rising prices are actually the outcome of “40 years of wealth concentration and generational inequalities” in Western societies, Deluard wrote. He pointed out that Baby Boomers have by and large accumulated wealth in ever more valuable equity portfolios and real estate holdings, while “GenZ-ers and Millennials must pay 4.5 times more than their parents for their share of the American Dream.”

Cost of the American Dream Basket* in Hourly Minimum Wage 
*25% S&P 500 Index / 25% US Bonds / 25% Home / 12.5% College / 12.5% Healthcare

Source: Bloomberg

The bitter medicine that will right this generational imbalance and put 21st-century economies on a healthier course is inflation, Deluard stated.

“Secular (long-term) inflation will increase interest rates and risk premia, causing the value of bonds, stocks, and homes to drop. The cost of higher education may fall as colleges adjust to smaller students’ cohorts. The numerator (asset prices and education costs) may fall, and the denominator (real wages) may rise until this ratio normalizes.”

In short, there will be a transfer of wealth from the asset-rich generation (Boomers) to the labor-rich generation (Millennials and GenZers), freeing, in the process, the “frozen the economic, political, and demographic structure of Western societies.”

As Deluard observed in a recent video, the current situation may be unsettling, but it could well be echoing the scenario of the 1970s, in which several years of elevated prices were followed by the boom years of the 1980s.

Looking forward: technology and future growth

Whether inflation turns out to be a short-lived episode or a long-term scourge, the expectation that the 2020s will roar like economies did 100 years ago seems to be waning. One financial commentator even called it “delusional.” And yet, for all the ominous headlines roiling markets today, labor markets remain strong, wealth continues to grow around the world, and the decade could prove to be a rewarding one. 

Moreover, though we’ve been hit by a flurry of dark episodes, positive events could also show up unexpectedly. For example, in a December 2020 article, the Economist cited the work of three scholars who suggest that new technologies, such as artificial intelligence and robotics, are just at the beginning of a J-curve of improving productivity. Like electricity, which took years to be widely used, they argue that 21st-century technologies must first go through a period of early promise and then insufficient use – the bowl of the J – before taking off – the stem of the J.

In the meantime, if recent history is any guide, the 2020s won’t lack for excitement. And as the decade whips along, business owners and wage earners alike would do well to take inflation seriously and hedge their bets to the best of their (and their consultants’) abilities.

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