Will deglobalisation and demographics fuel inflation?

Deglobalisation was expected to rob the world of many of the cheap Chinese products that flooded the world following China’s accession to the WTO in 2001.

Financial markets are on tenterhooks ahead of the Jackson Hole symposium this week and particularly Fed Chair Powell’s contribution on Friday. The title for this year’s symposium is “Reassessing constraints on the economy and policy”. Whether Powell will stick to this topic is anybody’s guess. But it’s an incredibly important subject bearing in mind that the constraints on economic growth created by weakened global supply are responsible for much of the rise in inflation that we’ve seen over the past year, or so.

Another Fed official, Neel Kashkari of the Minneapolis Fed has already spoken this week and it is notable that his biggest concern is that the Fed is “misunderstanding the underlying inflation dynamics”. We say this because we think that’s exactly what the Fed is doing, and our argument on this relates back to these constraints on the economy that we mentioned earlier.

To make this clear, we need to go back to a time when there was no inflation in developed countries, which was as recently as the middle of 2020. For although it appeared to many that inflation was dead and would never return (the Fed and ECB even adjusted their strategies to deal with the dearth of inflation) we had a different view.

In short, deglobalisation and demographics would push prices higher over time. Not to the stratospheric levels we see today, but a modest rise over many years, even decades, as deglobalisation and demographics turned the inflationary tide. Deglobalisation, borne of trade frictions, particularly between the US and China under President Trump, was expected to rob the world of many of the cheap Chinese products that flooded the world following China’s accession to the WTO in 2001.

At the same time, the so-called “dependency ratio” which counts the number of elderly people relative to those of working age, has been projected to rise dramatically in the next decade, or two, especially in developed countries. This too has the potential to lift inflation as the elderly contribute to aggregate demand, but not supply.

Put deglobalisation and demographics together and it seemed to us a few years ago that inflation was likely to trend slowly higher in the developed countries over the long haul. Instead, what has actually happened since the start of 2020 is that these issues have been on steroids. Hence the inflationary pressure that we thought might accumulate slowly over time has been put on fast-forward.

Deglobalisation has surged far more than expected due to things such as supply chain tensions during COVID-19, distrust of China over the Covid outbreak itself and, more recently, the security of energy supply given Russia- Ukraine conflict. In terms of demographics, the extreme tightness of labour markets right now says less about rampant demand and more about the choices being made by workers, especially those close to retirement age that have decided to leave the workforce early due, in part, to COVID-related concerns.

Migration trends have also contributed as these seem to have reduced working age labour supply in countries such as the US and UK. Now clearly this concentration of supply-side pressure in such a short space of time has led to an overshooting in inflation given that demand was in a post-COVID recovery phase. Nobody, including ourselves, is suggesting that annual CPI inflation will stay close to double digits in major countries.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said advanced countries would be more likely to see inflation above their 2% targets than below, but not near-10% levels over the long haul. However, the danger is that central banks see today’s inflation as a temporary miss-match of supply and demand and that once the former is reduced sufficiently through higher rates, the inflation problem will end.

“The market too seems to be pricing things this way. But if, like us, you think that underlying long-term inflationary momentum will still be increasing even once headline rates fall back to near-target levels, then there’s a clear risk that policymakers will misjudge the underlying inflationary dynamics – and that will come at a cost of higher yields”, said Mr. Steve Barrow.