The current inflation still looks to be a transitory phenomenon

Inflation data continues to come in from various nations indicating an ongoing escalation in prices dominated by energy and cars (in the US), housing and transport (UK), housing and transport (Australia) and so on. The major question I always ask is this: What would you expect to happen after a major global pandemic that has lasted more than 2 years and is still not resolved and which has closed factories, ports, transport networks, made workers sick so they cannot work, choked shipping, kept people at home while governments have to varying extents maintained their income, shifted spending to home maintenance etc away from haircuts, and the rest of it. And then, add an uncompetitive cartel that manipulates supply to gouge profits (OPEC). And on top of all that have some bushfires and floods around the place. And to even top all of that have a character who thinks he is a Tsar invading a neighbour and creating havoc and destruction. What else would you expect? Oh, its all down to QE and fiscal deficits, I hear them say. Modern Monetary Theory (MMT) again – now we know those ideas are defunct. We told you so! And repeat. Interest rates have to rise. Repeat. At least the ECB seems to understand the situation more than most, which is something.

In Issue 2 of the 2022 Volume of the – ECB Economic Bulletin – there is an interesting information ‘box’ – Supply chain bottlenecks in the euro area and the United States: where do we stand?

The Introduction to the Bulletin notes that:

1. “The Russian invasion of Ukraine will have a material impact on economic activity and inflation through higher energy and commodity prices, the disruption of international commerce and weaker confidence” – Yes.

2. “Inflation has continued to surprise on the upside because of unexpectedly high energy costs” – Yes.

3. “Longer‑term inflation expectations across a range of measures have re-anchored at the ECB’s inflation target” – Yes. Read again!

4. “The Governing Council sees it as increasingly likely that inflation will stabilise at its 2% target over the medium term” – Yes. Read again! That means transitory!

It also means that QE and fiscal policy is not driving this episode.

It also means that rising interest rates will do nothing to bring the inflation rate down and may actually exacerbate it by adding to unit costs.

5. “Supply bottlenecks are expected to start easing during 2022 and to fully unwind by 2023” – Maybe. Transitory drivers! (Hopefully if we get through the virus).

6. “The impact of the massive energy price shock on people and businesses may be partly cushioned by drawing on savings accumulated during the pandemic and by compensatory fiscal measures” – Yes. Note the need for compensatory fiscal measures, which do not mean extra stimulus, but real income protection to avoid a recession compounding the real income losses from the temporary inflation.

More on this later.

7. “Energy inflation, which reached 31.7% in February, continues to be the main reason for the high overall rate of inflation and is pushing up prices across many other sectors. Food prices have also increased, owing to seasonal factors, elevated transportation costs and higher fertiliser prices. Energy costs have risen further in recent weeks and there will be more pressure on some food and commodity prices owing to the war in Ukraine” – Yes.

All interrelated and not much to do with demand-side pressures.

There is some uncertainty as to the duration of this inflationary episode – “given the role of temporary pandemic-related factors and the indirect effects of higher energy prices.”

8. “Various measures of longer-term inflation expectations derived from financial markets and from surveys stand at around 2%” – Yes.

So no-one is really thinking that the inflation is anything but a transitory, ephemeral episode driven by various extraordinary factors that will eventually abate.

How long before abatement?

Uncertain.

Doesn’t that stretch the meaning of transitory?

Not at all.

Transitory doesn’t mean short-term necessarily. It means as long as the extraordinary events are driving the show.

When the supply chain adjusts to the disruption – remodels itself, ships start going where they are required and shipping companies stop gouging, and workers stop getting sick, and all the rest of it, then we will see.

Meanwhile Russia has to head East out of Ukraine and OPEC has to be pressured to stop its folly.

The ECB information box – Supply chain bottlenecks in the euro area and the United States: where do we stand? – is really an interesting and clever piece of research work.

They produced this heatmap graphic:

The heatmap uses data from a multitude of sources (US Bureau of Labor Statistics, European Commission, ISM, IHS Markit, Bloomberg) and is based on calculations of Z-scores, which are statistical results derived by subtracting the mean from the observation at time t and standardising by dividing by the standard deviation of the data series.

The ECB calculate the summary statistics – averages (means) and variation (standard deviation) – from January 1999 to the present and the Z-scores are based on annual growth rates.

So the darker the orange the greater the supply shortages (relative to demand) and the darker the blue indicates an abundance of supply relative to demand.

The experience for the Euro area and the US is broadly similar.

The heatmap shows that during 2020, the first year of the pandemic, demand fell away relative to available supply.

But “over the course of 2021” all the indicators moved to orange of various intensity and that state persisted up to February 2022 (so far that is).

The survey evidence the ECB elicited shows that “supply issues have generally not eased over recent months and are expected to continue throughout 2022.”

You can learn more about this survey evidence from this article – Main findings from the ECB’s recent contacts with non-financial companies – which appeared in the January issue of the ECB Economic Bulletin (1/2022)

The main, ongoing supply disruptions are in “transportation and logistics” – shipping, trucking, ports, etc.

The ECB analysis suggests that the January/February 2022 data is indicating that these major drivers of the heatmap patterns:

… have peaked and started to ease in both economies

Firms are starting “to rebuild inventories and the bottlenecks may be easing.”

But the spread of the new Omicron variant is creating further uncertainty with the “potential closure of factories and ports” and:

… there might be setbacks to supply chains if China continues to adhere to a strict zero-COVID strategy.

And, of course, don’t mention the war in Ukraine.

The ECB also noted that:

Supply chain bottlenecks stem from the interplay of several factors. First, the strong rebound in global demand for manufacturing goods, in part induced by the rotation of consumption away from services in the context of the pandemic-related containment measures, was not matched by an equal increase in the supply of goods. Second, some sectors have been hit by severe supply shortages, particularly of semiconductors, with supply struggling to accommodate the surge in demand for electronic products and equipment, and in the automotive sector …

So the pandemic caused sectoral imbalances to emerge which resulted from the reswitching of expenditure from services to goods, with major disruptions on the goods sector to respond, while the services sector was in a state of major excess supply capacity.

Abnormal and temporary.

I considered that reswitching of expenditure in this blog post – Central banks are resisting the inflation panic hype from the financial markets – and we are better off as a result (December 13, 2021).

With the December-quarter data for the US now available, I can update the graphs I produced. Last time, I used nominal aggregates to show the monetary pressures.

This time, given inflation is relatively high, I am concentrating on the real side of the economy which provides a better measure of the underlying pressures in output and real demand.

The first graph shows the path of real GDP from the March-quarter 2010 to the December-quarter 2021.

The red line is the average quarterly growth rate up to the December-quarter 2019 (the peak before the pandemic) extrapolated out to the most recent quarter. It tells us what would have happened if the US economy had have continued growing on that average growth rate trajectory.

You can see that the economy has still not reached the level that it would have if the pandemic had not disrupted pre-pandemic spending and production patterns.

As at the end of 2021, the trend index was 104.6 points, while actual GDP was 103.3 points.

The next two graphs tell what was going on in the goods- and service-producing sectors to deliver this aggregate result.

The pandemic did three things in this context.

First, the government stimulus payments, though imperfect, helped maintain incomes and spending capacity among households.

Second, the lockdowns prevented consumers spending on services by and large – hospitality, entertainment, travel etc.

And with income still intact, the spending shifted to goods-production – renovations, gadgets, flat-screen TVs, you name it.

Households brought forward spending plans on some things while normal spending patterns were short-circuited by the inability to spend on other things.

Third, the lockdowns and health concerns also reduced the capacity of the goods-producing sector to meet the new demand. This is what we are referring to when we talk about supply-side bottlenecks.

If workers are locked down, getting sick, and ports and freight terminals are disrupted, the normal smooth supply chain is interrupted and so there are inventory shortfalls, delivery delays and the like.

Then overlay market power – which allows producers, wholesalers and retailers to profit gouge the shortages via mark-up increases and you see the problem.

The following graph shows the expenditure on goods in the US – actual and trend (calculated in the same way as before). You can see what happened.

The expenditure on goods has shot up – well above the previous trend, upon which decisions about productive capacity and investment were being made.

The supply-side in the productive goods sector simply cannot adjust that quickly to such rapid (and artificial) shifts in demand and so the conditions for price rises are in place, given the market power held by price setters.

The next graph shows why the total GDP (the first graph shown) has only just recovered to its pre-pandemic level, while expenditure on goods increased so much.

It shows expenditure on services in the US is recovering but still well below where it would have been had the pandemic not hit and the average growth path prior to the pandemic continued smoothly.

So the pandemic has created a combination of supply constraints and rapidly shifting demand patterns.

All of which are likely to be temporary in nature.

You can already see the demand for goods abating and the rise in services expenditure.

This is especially relevant now that personal consumption expenditure in the US is in decline.

I analysed that issue in this blog post – The last thing policy makers should be thinking about right now is creating a recession (February 14, 2022).

Conclusion

The LA Times article (January 13, 2021) – Inflation: What’s driving it, who benefits and when will it end? – captured the problem well.

It reported that:

The pandemic has caused enduring problems with the shipping, unloading and delivery of goods around the country, notably at the crucial ports of Los Angeles and Long Beach …

production pullbacks continue to reverberate. A shortage of semiconductors has limited car production, which in turn has raised used car and rental car prices sharply. The pandemic also saw a wave of bankruptcies among U.S. oil producers as the economy briefly came to a standstill. Now, oil demand has recovered, but supply has not …

If not for the Delta wave, maybe factories would have been running at full steam in China and Vietnam and Taiwan, and we would get the parts and semiconductors that we need to produce cars and washing machines and wearable goods in the U.S. …

Some also question the need for the Federal Reserve to take action at all, if it’s all being caused by the pandemic. If the supply chain issues were resolved, wouldn’t inflation also take care of itself? …

If the pandemic is transitory, inflation should also be transitory …

I think that analysis is on the mark.

It doesn’t mean the inflation is unproblematic.

It doesn’t mean governments should not try to use the policy levers they have to attenuate the price rises. I will write more about that soon.

It just means that it is the result of an extraordinary conjunction of events that are unlikely to persist.

That is enough for today!

(c) Copyright 2022 William Mitchell. All Rights Reserved.