FOR nearly half a century, inflation in the US was headed one way: down. Since the Great Inflation of the 1970s, the US has achieved a remarkable decline in inflation, supported by structural factors that included globalisation, demographic changes, and rapid technological advances.
Fast forward to today, the US Federal Reserve faces very different circumstances: record low unemployment, strong wage growth, and rates of inflation that are far above the central bank’s target.
A key question facing central banks today is whether the observed inflationary shocks of today are cyclical or structural in nature, ie will they revert over time or do they reflect fundamental and permanent shifts in inflation pathways?
Oil prices to stay higher longer
It used to be that producers of fossil fuels would respond to such price signals by swiftly ramping up output and investment. Not this time.
Climate change has led to unprecedented pressure on oil and gas (O&G) firms to shift away from fossil fuels. As a result, there has been a structural under-investment in new production as investors increasingly avoid industries that produce fossil fuels and heavy carbon emissions.
Besides, there is no evidence that oil demand is in structural decline. If anything, fossil fuels are not going away anytime soon. The increase in renewable energy has not been keeping pace with rising energy demand. The world will have to tap fossil fuels to meet the rest of the demand.
Furthermore, renewables are at the mercy of the weather. In recent years, climate-driven droughts have triggered the biggest disruptions in hydropower generation in decades.
Meanwhile, wind droughts have caused wind turbines to stand still, significantly curtailing the generation of wind power. This means that fossil fuels are still needed as back-up fuel when renewables fail to carry through.
Make no mistake, fossil fuels are here to stay. With the structural under-investment in upstream oil and gas assets likely to persist, this is setting the world up for an even tighter energy market in the years ahead.
Green transition to be inflationary
The transition is likely to create a huge boom in demand for metals such as cobalt, copper, nickel, and lithium that are vital for the technologies underpinning everything from electric cars to renewables. The bad news, however, is that current supplies of these critical metals are inadequate to satisfy future needs.
Don’t count on supply to ramp up quickly in the short-term: building mines can take anywhere between five and 25 years. At the same time, investment in mines has been depressed by environmental, social and governance (ESG) concerns with mining companies under increasing pressure to source metals responsibly.
The unintended result of the green transition will likely be “green-flation”, sharply increasing prices for the metals and minerals that are critical to the transition.
But herein lies the paradox: the harder the world pushes the transition to a greener economy, the more expensive these metals will get. We should be under no illusion that the green transition will be a painless one.
Food prices on upward trajectory
Until recently, the Russia-Ukraine war has been one of the key drivers of food prices, and unsurprisingly so as both countries are agricultural powerhouses. Fears that food exports would be disrupted by the war – and that shortages would persist – have led to a sharp surge in food prices this year.
The impact of climate change will also continue to challenge agricultural yields, making it a long-term driver of food price inflation. Good harvests need good – or at least moderate – weather.
However, farmers have been confronted with rising instances of extreme weather patterns. China, the world’s largest wheat producer, has been grappling with scant rainfall and one of the most severe heatwaves in six decades.
Extreme temperatures have also sapped food production in India and Europe. The Horn of Africa is being ravaged by its worst drought in four decades.
Meanwhile, food protectionism has been on the rise as governments try to safeguard local supplies. India, the world’s biggest rice shipper, has been discussing curbs on rice exports as its domestic supply is under threat.
Earlier this year, India also announced restrictions on the export of wheat and sugar. Indonesia imposed a ban on palm oil exports in April, while Malaysia announced a chicken export ban in June. These countries are not the first to engage in food protectionism – and they won’t be the last.
Deglobalisation to drive up inflation
And then there is the slow-burning threat of deglobalisation.
Globalisation has held down prices for three decades. The rise in global trade with the entry of China and Eastern Europe into the global trading system has brought about greater competition and lower tariffs, thus reducing the prices of many manufactured goods.
The large-scale shifts in production facilities to low-wage countries have also suppressed wages and contributed to lower inflation.
But this powerful disinflationary force is now in retreat.
Even before the US-China trade war, growth in the volume of international trade has already been slowing significantly. With geopolitical tensions now on the rise, protectionism and trade conflicts will likely be a regular occurrence, putting the brakes on global trade.
The trend of “reshoring” – shifting manufacturing back to home country – to improve supply chain resiliency as well as “friendshoring” – shifting manufacturing to countries with shared values – will reduce efficiency and international access to cheap labour, both of which will drive up inflation in the long-run.
Positioning in era of high inflation
However, we note that tighter monetary policy will do little to address some of the structural drivers of longer-term inflation as mentioned earlier.
The Fed can bring down inflation to its 2% target by hammering demand with substantially higher rates, but it risks pushing the US economy into a deep recession.
We believe the Fed will eventually accept higher inflation to avoid inflicting unnecessary pain on the economy. We see longer-term inflation settling at around 4%. – Sept 20, 2022