What are the causes of the surge in inflation and what mistakes are the central banks making?
China: A “country to control global inflation”
In “Monetary policy in a good spot“, Claudio Borio et al. discuss how the consequences of globalization, particularly China’s accession to the World Trade Organization (WTO) and the collapse of the Soviet Union, exerted structural disinflationary pressures that outweighed domestic inflation catalysts in advanced economies:
“One likely candidate is globalization, in particular the entry into the trading system of former communist countries and many emerging economies that have liberalized their markets – countries that have also tended to resist exchange rate appreciation. As argued and documented in more detail elsewhere (Borio (2017)), the entry and increased importance of such producers is likely to have weakened the pricing power of firms and, more importantly, of labor, and made markets more competitive. During the cost convergence process, this would lead to persistent disinflationary winds, particularly in advanced economies where wages are higher. If this is true, developments in the real economy as a whole may have exerted persistent downward pressure on inflation, possibly outweighing the cyclical influence of aggregate demand.”
Monetary policy is effective in addressing cyclical deficits – akin to market instabilities following financial crises – but ineffective in addressing structural changes. Nevertheless, major monetary authorities interpreted the structural disinflationary pressures from China and the mixing of the previous Soviet states into global value chains (GVCs) – a long-term structural change – as no different from cyclical weakness as a consequence of short-term disturbances.
This contributed to the asymmetric monetary policy response of central banks, which loosen aggressively but tighten timidly so long as inflation stays below goal, no matter structural or cyclical causes. Borio et al. write:
“The second factor is an asymmetric policy response to successive financial and business cycles against the backdrop of prevailing disinflationary tailwinds associated with globalization. In particular, asymmetric responses were observed in the context of the financial boom and bust of the 1980s and 1990s, and the crisis surrounding the global financial crisis. As long as inflation remained low and stable, there was no incentive for central banks to tighten policy during the financial booms that preceded the financial stresses in both cases. However, there was a strong incentive to respond aggressively and persistently to combat the crisis and ward off any threat of deflation.”
Against this political backdrop, a structural disinflation factor, interpreted as a cyclical deficit, required an aggressive monetary policy response and a timid and delayed tightening of monetary policy in consequence. Persistently low rates of interest stimulated low-productivity sectors akin to the true estate sector and accelerated the misallocation of resources (misinvestment) and contributed to the spread of “zombie“-companies.
In fact, the Mixing of structural and cyclical inflation drivers by central banks, China became a key pioneer of quantitative easing (QE), although the “One country as a benchmark for global inflation“ has subsequently attracted greater attention available in the market.
Cost increase in China: China’s producers pass on higher prices to their suppliers.
After acting as “global inflation dampeners” for nearly twenty years, China’s producers faced an ideal storm of margin compression amid supply constraints and a recovery in demand in the primary half of 2021. As former People’s Bank of China (PBOC) official and Bloomberg economist David Qu noted, volatility in global commodities from crude oil and iron ore to copper – which together account for 70% of the fluctuations in China’s producer price index (PPI) – drove input costs to record levels.
Such a value increase in consequence provoked political reactions aimed toward curbing price growth. Macro investors acknowledge a gradual rise in U.S. import prices for goods from China, at the same time as many disagree on the effectiveness of price control measures or whether a recovery within the dollar triggered by a hawkish response from the Federal Reserve would cool the still-buoyant commodity market.
The rise in US import prices is intuitive: China’s producers cannot act as gatekeepers of inflation indefinitely, given higher input costs. While some observers, including Qu, argue that the price-absorbing effect stays intact, higher realized import prices support the thesis that rising input costs have undermined the inflation-dampening effect.
Asymmetric risks from central banks’ “blind spot” on inflation
If the Fed and other major central banks stick with existing frameworks and don’t distinguish between structural and cyclical inflation catalysts, China’s less effective “inflation dampening” capabilities could lead on to fundamental market shifts.
As a part of a successful price control campaign by Chinese regulators and renewed global weakness in commodity markets as a consequence of the strong dollar and the Fed’s restrictive stanceChina’s producers could start exporting inflation deficits again and help move closer to what the Fed is predicting as a “transitory” inflation forecast. But this doesn’t mean latest developments in asset valuation.
Conversely, unsuccessful price controls by the Chinese authorities and continued strength in commodity prices could increase pressure on China’s producers and result in a stronger inflation transmission to developed markets. Few investors have experience managing risk in elevated inflation, and a move away from the Fed’s dovish policy or political support for asset prices could negatively impact dangerous assets and government bonds (and negatively impact risk parity complexes and leveraged strategies).
The Fed could change course and treat inflation pressures from China as “structural” and conclude that they don’t warrant a change in policy. But that will likely draw public criticism and increase political risks, especially since former Fed officials hold vital government positions and head influential research institutes. As such, some may interpret changes to past policies as an admission of “policy mistakes.”
Market participants face asymmetric risk-reward trade-offs: they’re bracing for a return to the low-inflation establishment and expecting China to stay an inflation “black hole” to justify a protracted monetary policy adjustment, or they’re bracing for an inflationary shift that increases uncertainty in major asset markets. The likelihood of those two outcomes is roughly equal, however the establishment scenario could lead on to muted asset appreciation, while persistent inflationary pressures could lead on to a big pessimistic repricing of “policy-supported assets.”
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Photo credit: ©Getty Images / davidfillion
