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CENTRAL BANKS FEAR INFLATION DEFINES A NEW LONG-TERM REALITY
Central bankers fear that the recent, prolonged global rise in prices has sunk roots into the global economy, The Wall Street Journal reported.
To counter price pressures brought by chronic shortages of labor, materials, and cheap energy, the banks may need to raise interest rates significantly higher for longer than expected, leading to lost jobs, weaker GDPs, and more frequent recessions, the WSJ said.
The U.S. Federal Reserve’s aggressive campaign of interest rate increases may be a taste of the future, analysts told the WSJ.
“The global economy is undergoing a series of major transitions,” Mark Carney, a former governor of both the Bank of Canada and the Bank of England, said in a March speech at an economic conference.
“The long era of low inflation, suppressed volatility, and easy financial conditions is ending,” he warned.
Three forces that defined that “long era” seem to be waning, according to the WSJ.
First, globalization kept factories on the move, relocating to countries offering the cheapest labor. That kept inflation low, with the cost of goods in the U.S. rising an average of 0.4 percent annually during the first 20 years of this decade.
The post-COVID shortage of everything from shipping containers to computer chips has thrown globalization’s drawbacks into relief and spurred manufacturers to bring supply chains closer to home, as highlighted in our Top 2022 Trend of Self-Sufficient Economies.
“If you had all of your supply chain in just one country, you have to question why take that risk in a world where [viruses] could hit or country relations could deteriorate or wars could happen,” Thomas Barkin, president of the Federal Reserve Bank of Richmond, said in comments quoted by the WSJ.
Second, labor costs kept inflation low because hundreds of millions of low-wage workers were added to the labor market, especially in Asia. Now that trend has run its course and a glut of cheap labor has given way to a shortage of able and available workers in many parts of the world.
Meanwhile, the U.S. labor force has shrunk by 2.5 million workers in the last two years, an analysis by the Federal Reserve Bank of Kansas City found.
At the same time, the U.S. has slowed the pace of immigration that used to buoy the number of available workers.
That loss of workers on two fronts has pushed up wages, fueling inflation.
Third, commodities producers and energy companies have slackened their pace of investment over the past decade, leaving them short of capacity as demand soared after 2020.
In the past, the main economic dangers were “demand shocks,” consumer spending weakened and the job market softened.
In the U.S., the Fed dealt with those by dropping interest rates, which brought supply and demand back into balance, as after the September 11 attacks and the Great Recession in 2008.
However, now central banks are confronting “supply shocks,” in which there are not enough raw materials, goods, or workers, thus hobbling the economy’s ability to produce.
To rein back inflation, banks now must raise interest rates, which will discourage consumer spending, hamper economic growth, and cost jobs.
Partly because of 30 years of low inflation, central bankers were slow to recognize that today’s inflation was not a blip but a gathering wave across the global economy.
The risk is that people will come to see inflation as normal, which discourages savings—a significant source of capital to build houses, start businesses, and make other investments—and encourages spending before prices rise again.
The mentality of “spend now or pay more later” itself tends to drive prices higher, especially in an economy characterized by shortages.
Meanwhile, an aggressive schedule of interest rate hikes derails traditional investment strategies based on stocks and long-term government bonds.
In the U.S., Fed chair Jerome Powell is likely to err on the side of raising rates higher than needed to tackle inflation, several former Fed officials who know him told the WSJ.
Powell has said his primary goal is pound inflation back down to the Fed’s target annual rate of 2 percent.
“We cannot fail at this,” Powell said in 23 June Congressional testimony, “and we will not fail.”
What costs that will entail are yet to be learned.
TRENDPOST: As we pointed out in articles such as “Argentina’s Interest Rate Hits 44.5 Percent. U.S. Should Be 9 Percent” (29 Mar 2022) and “Eurozone Inflation Rises to 8.9 Percent in July” (23 Aug 2022), to halt inflation the Fed would have to raise interest rates to about 8 percent or more from their current level of about 2.5 percent.
To do that in a short amount of time would crash the economy into a major recession. The Fed is unlikely to be willing to risk that.
And now, with the new inflation numbers, they will most likely jack up rates another 75 basis points next week. But even that small a rate hike when compared to inflation has rattled equity markets. Thus, the worst is yet to come: Dragflation, negative GDP growth and rising inflation.
TREND FORECAST: Central banks in Europe and the U.S. will not raise interest rates high enough fast enough to grab inflation the way that banks in Mexico or Argentina have.
Price increases will continue to ease largely because consumers pare back spending simply because prices are high, not because central banks make token rate increases.
Those increases will have only an indirect effect, particularly on the housing and vehicle markets, which make up a major share of the economy. Cutbacks in those purchases gradually will ripple through the economy, but they are unlikely to have the dramatic effect needed to curb inflation in the near term.