In the last episode we talked about the energy crunch; the skyrocketing gas prices, geopolitical movements around gas involving Russia, its neighbors, the EU, the US and even the immigration issues. There were also the dilemma’s around the shift to the new energy sources and the complex operational and geopolitical procedures around the transition from the old to the new and alternative energy sources, electric vehicles, shortage of semiconductors, lithium and China’s positioning in the alternative energy market.
Little did we suspect that the reform and legislation around fossil fuels would translate into an energy crisis and hence become one of the major drivers, and the inevitable consequence of what the central bankers are watching closely. Economists are trying to assess and decipher more and more of what went on during the last months, namely inflation.
In the last decade, we have been through so many different events, from “too big to fail”, to quantitative easing, to social media, to the tech revolution and the longest bull market in history lasting from 2010 to 2019, that we had forgotten about inflation.
The last time the market was worried about inflation was in 2007, when consumer prices rose rapidly, just before the US housing crisis in 2008. This was better known as “the subprime crisis”, from which all the subsequent crises stemmed with the expected domino effect.
The effects of 2008 were carried over into 2013 with the Greek and European debt crises. The effects continued to be felt until early 2020 when the Covid-19 pandemic hit with full force, striking a blow to the system’s most already vulnerable shell. Fear arose that history was repeating itself.
The fear of a global recession or something similar to what the world went through during the Great depression of 1929-1939 with all its consequences has prompted lawmakers to do all they can to counter the possibility of a steep economic downturn or a new depression.
Typically, there is no economic growth during a recession and unemployment rises. Sometimes, prices fall in a process known as deflation, which in itself, is not a bad thing for businesses and consumers. However, it is unfavorable for the financial sector and credit lenders, in other words, the banks. As deflation deflates debts, it decreases the value of the debt or the money lent.
Therefore, policy makers and central banks, including the European Central Bank (ECB) and the Federal Reserve (the Fed) have, since the beginning of the crisis, taken drastic monetary measures. On the one hand, they have lowered interest rates – a quite conventional tactic – but on the other, have made a less conventional move by buying bonds and other debt securities on the open market with newly-created bank reserves. They have also injected new credit, also known as “quantitative easing (QE)”, with the aim of increasing money supply and thus spurring economic activity on the domestic market.
For more than a decade now, policy makers have done their best to re-inflate prices in order to preserve the market from a deflation. They have done this by increasing the money supply to unprecedented levels, and distributing cheap money to households and businesses, and by keeping interest rates very low, close to zero.
However if all the measures implemented fail to bring about economic growth, in parallel with the re-inflating prices, we are then dealing with stagnation. Here, the economy will suffer from a phenomenon known as “stagflation”, which is as costly as a recession.
A LESSON IN HISTORY: THE USA IN THE 1970S
If the Great Depression of 1929-1939 is remembered like a plague in modern financial history that eventually led to the outbreak of World War II, the Great inflation of the beginning to the mid 1970s is remembered like an “energy Pearl Harbor”, in the words of President Richard Nixon’s top advisor at the time.
In 1964, inflation measured a little more than 1 percent per year, and had been in this vicinity over the preceding six years. Inflation began ratcheting upward in the mid-1960s and reached more than 14 percent in 1980.
The recession of 1973-1975 in the U.S. came about as a result of skyrocketing fuel prices, influenced by a booming global economy. OPEC had also raised oil prices and placed an embargo on oil exports to the U.S in the aftermath of the Yom Kippur war. As a consequence of this conflict, OPEC countries boycotted the US for supporting the Israeli army, and therefore the Arab embargo quadrupled oil prices. This came at a time when the US economy was struggling amid heavy government spending on the Vietnam War, as well as a Wall Street stock crash in 1973-74.
It was this economic stagnation, coupled with the high inflation that occurred during that period that gave rise to the term “stagflation”.
Those who remember the 1970s Great Inflation can also recall the following ingredients: high oil prices, thick sweaters, fire stoves, inflation, unemployment and finally, recession in 1981-82.
During that period, the CPI – core consumer price index – peaked to 13,5% with the result that inflation hovered stubbornly between 10 and 12% from February 1974 through April 1975. Between 1973 and 1975, the U.S. economy posted six consecutive quarters of declining GDP and at the same time tripled its inflation. Concurrently, GDP declined 4.7% in the US, 2.5% in Europe, and 7% in Japan, while the unemployment rate wiggled between 6% to 10 %, and almost peaked at 11%.
Up until that point, economists of the Keynesian school, namely the New Zealand born William Phillips and founder of a theory that goes by the name of “Phillips Curve” that later proved to be too simplistic and perhaps erroneous in some ways, thought that inflation was to be encouraged as it meant higher growth, even if the unemployment rate was high.
According to the theory of the late British economist, John Maynard Keynes, growth in the money supply can increase employment and promote economic growth. This theory was inspired in large parts by the dramatic memories of historically high unemployment rates in the United States and around the world during the 1930s. At that time, the Fed had more or less let the banking system collapse, allowing the money supply to dwindle and causing prices to fall. This brought about the deflation that contributed to the contraction of the entire economy.
According to Keynesian economic theories prevalent in the 1970s, inflation should have had an inverse relationship with unemployment, and a positive relationship with economic growth. Thus, rising oil prices should have ultimately contributed to economic growth. It was explained that increasing inflation should decrease unemployment, and that a focus on decreasing unemployment also should increase inflation.
The belief was that when labor demand increases, the pool of unemployed workers subsequently decreases and companies increase wages to compete and attract a smaller talent pool. And so companies pass along those costs to consumers in the form of price increases. Therefore any fiscal stimulus would increase aggregate demand.
At that time, president Nixon, who at first came to office as a fiscal conservative but later ran budget deficits, supported an income policy, and eventually announced that he was a Keynesian as the reelection year approached.
He exploited the idea that monetary policy can and should be used to manage aggregate spending and stabilize economic activity. It should be noted that this is still a generally accepted tenet that guides the policies of the Federal Reserve in the US and other central banks in the world today. During that time the Fed continued increasing the money supply and kept the interest rates low. But one big, erroneous assumption regarding the implementation of the stabilization policy of the 1960s and 1970s was that there was a firm and exploitable relationship between unemployment and inflation, where the policy makers thought that they could in the long term, lower the unemployment rates by introducing higher rates of inflation. This is how, according to some economists, the greatest failure of American macroeconomic policy in the postwar period was brought about.
A few years later, in 1979, Paul Volcker was appointed chairman of the Fed by the new American president, Jimmy Carter. Volcker was a strong supporter of aggressive monetary policies and tried to put a stop to inflation in the US, even if it came at the detriment of short-term employment. Under Volcker, the Fed raised the federal funds rate from 11% at the time to a peak of 19% in 1981. It reduced growth in the money supply, sending interest rates well into double digits, resulting in successfully lowering the rate of twelve-month inflation from a peak of nearly 15% to 4% by the end of 1982.
Though the Fed’s policy under Volcker was effective in reducing inflation, the monetary contraction—combined with the impact from the oil price shock— provoked a deep slump that raised the unemployment rate to 10.8%. This pushed the economy into the most severe recession since the Great Depression and spurred strong popular opposition.
So, stagflation finally ended, but at a huge cost. By the time America finally emerged from that slump, unemployment didn’t fall below 6% until late 1987.
WHAT HAPPENED IN 2021?
When it comes to figures, the current annual inflation rate in the US shot up to 6.8% in November 2021, (the highest since June 1982 and in line with forecasts), versus 10-12% in the 1970s.
According to Bloomberg, the national unemployment rate in the US in November 2021 was 4.2%. This is considerably lower than that of 1976, when unemployment was at the very high rate of 7.7%. Nothing like this has been seen in the U.S since the Great Depression.
As far as Europe is concerned, the annual inflation in the European Union was 4.4% in October 2021 (the highest figure on record in the 25 years that the data has been compiled), up from 3.6% in September.
One year earlier, that rate was 0.3%. The increase is caused mainly by the spike in energy prices, while the highest inflation is seen in Estonia, Lithuania, Hungary and Poland.
According to Eurostat, the statistical office of the European Union, the EU unemployment rate was at 6.7% in September 2021, down from 6.9% in August 2021 and from 7.7% in September 2020, versus 6-10% in the 1970s and early 1980s.
However, a 4% to 5% unemployment rate is considered to be full employment and is not particularly alarming. The
natural rate of unemployment represents the lowest unemployment rate whereby inflation is stable or the current unemployment rate with non-accelerating inflation.
Inflation has been hovering over us with several inflationary hikes, most recently in 2010-11; the spike was largely driven by the prices of goods, especially oil, whose prices are always volatile. Each rise was accompanied by dire warnings that runaway inflation was just around the corner. But such warnings proved, again and again, to be false alarms, up until the Covid pandemic of 2020.
The current inflation has a lot in common with that of the 1970s; the boom in global demand for energy, geopolitics influencing oil prices, and a decade of easy monetary policy with low interest rate, money supplies and plenty of liquidity.
However, the verdict is in the hands of the GDP; with 2.3% in 2018, 1.7% in 2019, −6.3% in 2020, and 5% in 2021 as confinement measures were gradually lifted, the OECD (Organisation for Economic Co-operation and Development) forecasts economic activity in the Euro area to expand by 4.3% in 2022 and 2.5% in 2023. France recorded the strongest quarter-on-quarter GDP growth (3.0%, compared with 1.3% in the previous quarter), followed by Italy (2.6%, compared with 2.7% in the previous quarter)
The US economy expanded an annualized 2.1% in Q3 2021, slightly higher than 2% in the advance estimate, but below forecasts of 2.2%. According to the OECD, United States GDP exceeded its pre-pandemic level by 1.4% in the third quarter of 2021.
That said, it is the end of the monetary easing for central banks. The Federal Reserve will increase the rates by three times in the coming year, with the first hike expected sometime in the spring of 2022. It will also end its Bond-buying/ Asset Purchase Program. The Bank of England (BoE) will follow suite and end its Bond-buying/Asset Purchase Program, and despite the sharp increase in the Omicron infection rates, will implement an increase of 0,15%. The European Central Bank (ECB), will likewise bring an end to its Bond-buying/ Asset Purchase Program, but has so far ruled out raising interest rates next year.
The world is experiencing a bottleneck problem, or better said, a supply chain clogging weighing on the semiconductor markets, now a major contributor to global inflation.
Ever since the pandemic struck, consumer behavior has shifted to consuming more goods than services. People are continually ordering innumerable items online, and demand has only increased with the pandemic. Overall consumption is up 3.5 percent since the pandemic began, so it’s no wonder that the ports are clogged while the shipping costs have reached new heights.
According to Politico, China’s harsh travel and transport restrictions are also an important factor that is being overlooked in creating “non natural” port clogging. With Beijing deciding to impose strict quarantine measures, including even on the crews of container ships, freight transport is being delayed, with its massive consequences impacting the rest of the world.
However while the EU politicians – Eurogroup President Paschal Donohoe and ECB chief Christine Lagarde – speak of “strong, swift and coordinated economic policy response of the European Union and its member states” during the pandemic regarding inflation, they never mention Beijing’s macro-economic role in the current inflation.
Western consumers are so used to inexpensive Chinese-made goods that even when these are no longer cheap, they continue buying. The Chinese Producer Price Index jumped 13.5% in October from one year ago, shooting up from September’s 10.7%. Vegetable prices jumped 16% in October, gasoline and diesel prices rose more than 30%.
The ongoing energy crunch was also a great contributor to the sharp increase in producer price inflation, as the cost of coal mining and processing has gone up enormously.
There is also the fact that the Yuan is currently at its strongest in more than three years versus the U.S. dollar. The last time it was at this level was in the summer of 2018, just before the trade war triggered by Washington. China responded by allowing its currency to devalue, making its exports more competitive with U.S. goods. Chinese manufactured goods are no longer cheap due to the its monetary policies and the ongoing energy crunch; yet European and American consumers want to continue buying. The inflation in China has transmitted itself to the rest of the world.
According to Morgan Stanley, China’s debt has grown by $4.5 trillion over the past 12 months, more than growth in debt for the U.S. ($2.2 trillion), Japan ($870 billion) and the euro area ($550 billion) combined, over the same period.
The majority of this debt creation in China has been directed toward infrastructure and property markets, feeding domestic demand, but it has lifted global commodity prices and China’s commodity-related producer price segments.
We are just stepping into 2022 and we are starting the year by looking at the global inflation in the eyes. But as long as it is accompanied by economic growth and healthy employment, the figures will not be that dangerous.
The market is divided into two camps, one – ‘Team Transitory’ – believes that the current inflation is transitory and will eventually pass and fade away, while the other is of the opinion that it has a more persistent nature because it is accompanied by lower growth rates, very similar to the ‘stagflation’ of the 1970s.
So far, the warnings about inflation have proved right, while the predictions by ‘Team Transitory’’ that inflation would quickly fade have proved to be somewhat naive.
Governments and central banks will do all they can to offset inflation. However, at the core of today’s inflation lie energy prices and all that is causing the imbalance of supply and demand. Therefore, as long as energy prices are not tamed, neither will the current inflation.