New era of inflation will bedevil central banks and bond markets
Structural changes – hyper-globalization, global demographic shifts, technological changes and decline in labor’s bargaining power – unleashed disinflationary forces that kept price pressures largely subdued for much of the first two decades of this century. But the pandemic shock and other recent developments suggest that we may now have entered a new inflationary era, one characterized by persistent upward price pressures. The consequences of this regime shift for financial markets and monetary authorities are yet to be fully understood.
China’s integration into the world economy and the information communication technology (ICT) revolution enabled the establishment of global supply chains and radically altered the cost of producing manufactured products. The rise of platform companies (e.g., Apple), contract manufacturers (e.g., Foxconn) and specialized logistics players (e.g., FedEx, UPS) enabled the creation of global multistage production networks. The resultant benefits (economics of scale, factor cost arbitrage) generated both substantial benefits for multinational companies and significant cost savings for Western consumers.
Now, with the re-emergence of geopolitical blocs and the widespread deployment of trade barriers, a shift towards de-globalization appears inevitable. But reshoring/nearshoring production will be a costly endeavor even though it may promote supply-chain resiliency.
Another factor – demographics – that had kept a lid on global inflation in the past is now expected to contribute to upward price pressures. The population growth rate and the population age structure can have significant effects on inflation. Research by Mikael Juselius and Elöd Takáts suggests that “the larger the proportion of young and old in the total population, the higher inflation. Put another way, when the working-age population is larger, the effect is disinflationary.”
As East Asian and Western economies experience rapidly-aging populations and shrinking workforces, upward pressure on inflation is a likely outcome in the years ahead. Growing barriers to legal migration are likely to compound the problem.
Skill-biased technical change (alongside globalization) and diminished worker bargaining power had led to a decades-long decline in the labor share of income. A sharp drop in unionization rates (particularly in the U.S.) and a rise in market concentration were two notable factors that contributed to labor’s relative loss of bargaining power vis-à-vis capital.
The pandemic shock and resultant changes in labor market dynamics has caused a much-needed improvement in the wage negotiating position of workers (in fact, low- and mid-skilled workers have seen some of the biggest wage gains). There has also been a widespread push to boost unionization levels and restore collective bargaining rights in the US. The longer-term repercussions of these developments, while positive from a distributional standpoint, are likely to be inflationary.
Speeding up the process of decarbonization poses a new challenge to central banks and their efforts to keep inflation near the 2 percent target over the medium run. As Isabel Schnabel, an executive board member of the European Central Bank, recently noted: “As we build a more sustainable economy, we face a new age of energy inflation with three distinct but interrelated shocks that can be expected to lead to a prolonged period of upside pressure on inflation.”
The three shocks noted by Schnabel include “climatflation” (rising costs associated with the increasing frequency of natural disasters and extreme weather events), “fossilflation” (legacy costs associated with shifting away from fossil-fuel based energy sources), and “greenflation” (surging cost of key metals and minerals, such as nickel, lithium, cobalt and copper, that are necessary to build a greener economic future).
All in all, if structural forces have indeed shifted from being long-term disinflationary to now being long-term inflationary, tough challenges lie ahead for central banks in both the U.S. and Europe. Bringing inflation back down to the 2 percent target is likely to require a significant trade-off between price stability and maximum employment. Furthermore, the recent loss of central bank credibility is likely to raise the cost of restoring price stability.
If we do end up in a prolonged period of above-target inflation, the four-decade long bull market in bonds will finally be over. Former Federal Reserve Chair Ben Bernanke summarized the drivers of long-term bond yields as follows: “To explain the behavior of longer-term rates, it helps to decompose the yield on any particular bond, such as a Treasury bond issued by the US government, into three components: expected inflation, expectations about the future path of real short-term interest rates, and a term premium.”
If expected inflation and term premium, which had both been subdued for much of the past two decades, were to rise noticeably and persistently, the bond market is in for a significant surprise. Despite recent increases in U.S. Treasury bond yields, they are still relatively subdued and may not appropriately reflect the potential risk of elevated inflation over the medium or long run.
Besides bond investors, the U.S. Treasury is also keenly aware of the potential risks posed by a spike in borrowing costs. Higher interest rates will have a significant effect on the government’s ability to sustain record levels of public debt.
We are facing an extraordinary moment of uncertainty regarding the future inflation (and interest rate) outlook. Will we relatively soon return to the low rate, low inflation and low growth (characterized as secular stagnation) dynamic that was the hallmark of the post-financial crisis era? Or are we entering a new era of sustained higher rates and elevated inflation? Nobody knows the answer for sure, but we shouldn’t underestimate the probability that we are in the midst of a consequential inflation regime change.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.