Forget, as expected, floating around 1.5% as in the last decade.
Does this mean that this paradigm shift will cause inflation to remain constant at 4% in the future?
Not necessarily.
But it certainly means that volatility and uncertainty around inflation will be greater, and that’s all that matters for global macro portfolios.
Let’s analyze together the factors that will drive inflation in the future, taking into account that there is a big difference between structural inflation (within a horizon of 5 to 10 years) and the inflationary cycle (within a period of 6 to 12 months).
Structural factors of inflation include, among others, demographics, globalization, the struggle between labor and capital, and energy policies.
Instead, the short-term inflation cycle is driven primarily by the printing of money from the real economy (credit and fiscal).
So, here are the three factors that will drive inflation fluctuation over the next decade:
1. Demographics, deglobalization and labor versus capital (structural)
There are two schools of thought: weak demographics are disinflationary (reduces organic growth rates and consumption while increasing the propensity to save) or long-term inflationary (skilled labor shortages lead to higher wages, older people will spend more due to larger social safety nets on healthcare, etc.).
I think they are both right to some extent if you apply the right context: we live in a globalized economy.
Using that context, it is clear that the last 10 to 20 years have seen a perfect confluence of disinflationary forces: demographic weakening in developed countries (chart on the left) generated disinflationary conditions and we solved the problem of labor shortages. work by offshoring production to China, which meanwhile was benefiting from a wide availability of cheap workers (right graph).
A great cocktail for disinflation: weakly developed market demographics plus cheap outsourced labor in Asia.
But here’s the problem: this combination will no longer exist.
The rapid reversal of Chinese demographics (red dots, right chart) and a marginal push toward deglobalization mean that developed market economies will no longer be able to access a growing pool of cheap labor to the same extent. This will force developed markets to shift some of their production domestically and, at the margin, raise wages for scarcely available skilled domestic workers – some effects are already visible.
Shortage of skilled domestic labor
The counterarguments here are two:
1. Manufacturing and cyclical industries that will experience labor shortages represent a small proportion of the overall labor market and that is because
2. We live in a technology-driven world and that trend will continue.
The typical American company that needed 8 employees to generate $1 million in revenue in the 1990s now only needs 2, in a struggle between capital and labor that does not bode well for wage bargaining power.
Today’s economy is much less labor intensive and less unionized than in the 1990s.
Overall, my view here is that the magical combination of disinflationary tailwinds that we have experienced over the last two decades will not be repeated in the future, within the range that pushes structural inflation a little higher, but let’s not forget that we will continue to live in a (somehow) globalized world, driven by technology.
In other words: inflation will be much less predictable in the future.
2. Energy Policies (structural)
The attempt to reach net zero (ehm transition) will definitely be a net inflationary force over the next 1-2 decades.
It’s quite simple: as policymakers penalize (read: tax) industries that produce excess CO2, the economy will somehow force countries to decarbonize, but interestingly, in the initial phase of the transition, the world will continue to consume fossil fuels whose after-tax prices will be higher (left graph).
Additionally, the net zero transition requires dramatically more green commodities (for example), which is an underinvested industry, as shown in the graph to the right.
Supply and investments in green commodities take time, while the increase in demand will be sudden: the likely result is that commodity prices will have to adjust upwards somewhat, thus fueling inflationary pressures.
The counterarguments here are that the transition to net zero emissions will take much longer and be much smoother than anticipated, and that current assumptions about the amount of green commodities needed do not take into account technology: we will probably find smarter ways to generate the same result requiring fewer inputs.
My view here is similar to the demographic story: at the margin, the net zero transition will be net inflationary, but look at the graph on the left: the volatility (rather than the “new average”) of inflation will be the key change. .
Conclusion: structural inflation
The “new average” of structural inflation over the next two decades is likely to be higher than the 1.5% we experienced in the 2010s – how high?
It’s very hard to say whether it’s 3% or 5%, but I’m much more confident in making another call: Inflation will be much more unpredictable and swing much more violently over the next two decades.
3. Money printing (cyclical)
Central banks do not print inflationary forms of money: commercial banks (credit) and governments (deficits) do.
This is why years of QE did nothing about inflation, but a globally concerted exercise of printing real economy money in 2020-2021 woke up the inflation beast: we printed real economy money through of massive deficits and credit creation, and inflation appeared promptly in 2022.
Where next?
My TMC Credit Impulse measures money printing in the real economy and predicted (with a lead time of 18-24 million) major inflationary pressures in 2022 and the following disinflation trend we have seen in 2023 so far.
Now it says headline inflation will trend around 1% (!) in June of next year alone, with annualized inflation running at around 2-2.50%: the Fed will feel the job is done.
2% inflation seems impossible to supporters of the “new inflation paradigm,” but that misses a key point.
We could also have average inflation of 3-4% over the next two decades (structural), but higher inflation volatility could easily result in further disinflation in 2024 (cyclical).
Don’t confuse long-term structural trends with the short-term inflationary cycle!
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