Philip Hergel
Senior Quantitative Analyst
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Midway through 2021, we shared our outlook on inflation, forecasting that the surge in prices was most likely temporary. Equipped with more time, data, and analysis, we are now reconsidering this idea of transitory inflation. In the table below, we present a useful framework to help identify and distinguish various short- and long-term inflation trends, and to help understand their future impacts on inflation in 2022 and beyond.
Pushing Inflation Down
In the short term, several pandemic-induced forces that initially contributed to inflation are now likely to dampen inflation, assuming progress continues to fight COVID-19 and we avoid repeating the draconian global lockdown measures of 2020.
There are early signs that we are past the worst of supply chain disruptions. For example, freight rates remain elevated but are slowing, the number of cargo ships backed up outside global ports is falling as goods are being unloaded and distributed, and unemployment is declining globally as workers spend down their pandemic stimulus checks and return to work.
The pent-up demand brought on by stimulus checks and lockdown is declining. During lockdown, demand for goods surged. But as vaccination rates increase and economies open, demand for goods and services will become more even.
The base effect — a simple fact of arithmetic that compares current prices to the same period of the previous year — will reduce the rate of inflation, given that price levels are no longer being compared to levels depressed by the onset of the pandemic.
There are also some long-term trends which should continue to have a dampening effect on price levels in the coming years and decades.
Innovation and advances in technology have lowered inflation and price levels for decades. Factory automation, for example, directly reduces production costs and increases supply, both of which reduce inflation. Also, the travel industry allows us to shop from our home for a vacation across limitless options, all of which are competing for our consumption dollars. Last, a month-long subscription to the average streaming service — which offers unlimited access to a wide variety of entertainment — is cheaper than buying one movie ticket.
Aging populations are also pushing prices down. The old-age dependency ratio — which measures the number of people aged 65 and older relative to the working-age population — has soared from 13.9 in 1950 to 30 now and is expected to continue rising to 53 by 2050. This demographic trend indicates the population is aging and along with an older population come less consumption and more savings, both of which reduce consumer prices.
Pushing Inflation Up
Now to the more worrying structural trends that we predict will contribute to higher inflation over the long term.
In recent years, there has been a global movement towards deglobalization. The effort to shorten supply chains to protect domestic companies and workers became super-charged as the pandemic hit. By insourcing and reducing the length of the supply chain, not only do manufacturers protect the domestic workforce, but they also protect against the risk of supply disruptions, like we experienced early in the pandemic. The downside to relocating facilities back home is that manufacturers can no longer take advantage of cheap labor in developing economies, creating the potential risk for higher inflation.
“There is power in a factory, power in the land. Power in the hand of the worker. But it all amounts to nothing, if together we don't stand. There is power in a Union.” Singer-songwriter and activist Billy Bragg penned these lyrics more than 30 years ago to promote the power in labor. For decades, workers’ share of income and wealth has been shrinking. Now, labor’s power is increasing. Hourly earnings are rising close to 5% from year-ago levels, compared to 2.5% on average in recent pre-pandemic years. Personal income — a broader measure of compensation — is rising almost 10%. Headlines are full of stories of companies attempting to counteract the “great resignation” with signing bonuses, paying tuition, improving working conditions, and more. The effects are higher input costs and a potential wage-price spiral, which could increase prices for years to come.
Finally, the renewed push in ESG implementation could increase prices in the long run. Reducing a firm’s carbon footprint or implementing ethical corporate social and governance policies have costs associated with them. The same is true with investigating and modifying supply chains to reduce fossil fuel consumption or to protect workers’ rights. As global corporations adopt various ESG measures to create a more just and sustainable environment, they will inevitably take on added costs. With added costs come more inflation pressures.
Bottom Line: The abrupt and volatile price movements, as global economies reopened in the second half of 2020, were caused by temporary, short-term factors which are beginning to fade. While some long-term trends continue to weigh on prices, the pandemic has also introduced and accelerated other trends that will likely contribute to increasing inflation in the years ahead, and even decades to come. We are in the very early stages of a tug-of-war between these forces. While it’s unclear which side will win, we know for certain that the pandemic has shifted the playing field. Prior to the pandemic, authorities’ inflation targets were a ceiling, and many had difficulties getting inflation up to their targets, usually around 2%. However, long-term inflationary pressures have since emerged and these inflation targets could become a floor in the years to come.