The inflation debate

More money and more demand

According to Milton Friedman, inflation is always and everywhere a monetary phenomenon. It can only be caused by a rapid increase in the money supply. Post-Corona did succeed in doing so, with the total money supply increasing by 30 percent. Perhaps after the Great Financial Crisis, people thought that not enough money had been injected then. That mistake was not made again; this time it proved more than sufficient. Still, a properly functioning supply side of the economy could absorb much of that extra demand. That’s where things are going wrong, however, and strangely enough, only a relatively small part of that is due to the corona crisis. 

China, no longer an exporter of deflation

China is home to the world’s factories. Because of the coronavirus, parts of the Chinese economy go on lockdown from time to time. China takes strict action against outbreaks of corona and does not shy away from shutting down factories, cities, and even ports. What has nothing to do with corona, however, is that China is no longer an exporter of deflation. For years, China’s economy had to grow by exporting a lot to get everyone a job. Whereas ten years ago China’s labor force was growing by 15 million people every year, now it is shrinking by 5 million annually. This is the result of the one-child policy and the impending end of rural-to-urban migration. Before China, countries like Japan, South Korea, and Taiwan were the big exporters of deflation in Asia. For a country like China, there is no logical successor. Perhaps India, but for that, the share of the Indian economy in world trade is, for the time being, completely insufficient. 

Shortage of semiconductors 

More important than oil today are semiconductors. China spends more on semiconductors than on oil, and since the corona crisis, there has been a shortage of chips. It seems logical to explain this shortage by the corona crisis. Yet this is only half the story. Of course, the lockdowns created additional demand for PCs and consumer electronics, but the real problem is that there was insufficient investment in capacity. This was mainly due to the battle between China and the United States. After the effective boycott of Huawei, many chip producers became reluctant to invest, and we are now reaping the benefits of that. Now investment is picking up, but it may be several years before this capacity difficulty is solved. 

High energy prices

In terms of raw materials and energy, there is a long pig cycle. It takes years for investment decisions to lead to increased production. Since the oil price was cut in half in 2014, producers have become increasingly cautious. The release of the Responsible Development Goals in 2015 also kicked off the campaign to discourage new investment in oil. The same year, the governor of the Bank of England gave a speech warning commercial banks against investing in fossil fuels. The chances were that, because of the approaching energy transition, these would become ‘stranded assets’. Oil companies also had to deal with activists on their doorstep. Shareholders who conformed to the responsible development goals started asking critical questions. Suddenly it wasn’t so much fun to work for that big oil company anymore. Then, when a judge also ruled on the need to stop fossils, it was not logical for oil companies to start investing in full. Despite this pressure to stop investing in fossil fuels, we do continue to consume 100 million barrels a day, and we are now reaping the rewards in the form of higher energy prices. Next year, for the first time in history, there will be more demand than the supply of oil. Oil prices may continue to rise next year as well, but probably not as sharply as this year. 

Impact on economy

Rising inflation is a result of more demand and insufficient supply. In addition to developments in China, the shortage of semiconductors, and failing energy markets, shifting consumer preferences have also created a logistical nightmare. This is while production chains have become increasingly long and therefore more vulnerable in recent years. Just-in-time is now just-in-case. Companies need to start investing to make those chains robust again. A major obstacle is the lack of sufficiently qualified personnel. This is indirectly related to the corona crisis. Perhaps because some people no longer want to work for fear of corona, but it is also the baby-boom generation that has seized the opportunity to retire early. This has been made possible by the ample liquidity of governments and central bankers. As a result, house prices and the stock market are also providing the incentive to retire early. We are, after all, in the middle of the baby boom generation’s retirement period. For the record, that’s the 1945-1965 generation, so people aged 56 to 76. Once they retire, they are people who no longer produce, but who consume for years. In their lives, they saved one day or more in the week for retirement. Now they are going to spend it. By definition, that creates more inflation. The consequence of too low inventories, too long delivery times, and staff shortages is that more investment is needed. This is in addition to the investments required for the energy transition and the investments due to the recovery plans, especially those focused on infrastructure. 

Impact on politics

It has been a while since inflation has played a major role in politics, but rising prices are making sitting politicians unpopular.  Rising food prices are also causing social unrest. Especially in countries where a relatively large portion of disposable income is spent on food, this can even have a revolutionary impact. The French Revolution, the Arab Spring, and even the uprising in Tiananmen Square can be linked to sharply increased food prices for this purpose. Reagan won the election by asking voters if people could buy more in a store than they did four years ago. Now, Biden believes this negative political effect of inflation can be combated with an additional $1.75 trillion in social welfare spending on top of the $550 billion infrastructure plan, but critics claim it will only cause even more inflation. Meanwhile, Biden does seek help to reduce energy costs as quickly as possible. The downside is that investments there, too, will first cause inflation to rise, and only then, over time, can the benefits be reaped in the form of lower prices. 

Impact on monetary policy

Just over a year ago, monetary policy in the United States and Europe changed substantially. The objective is now an average inflation rate of 2 percent, which means that inflation may exceed 2 percent for an extended period after having been below it for years. Furthermore, central bankers no longer look at inflation expectations but instead rely on actual inflation. When inflation began to rise, central bankers were the first to confirm that it was temporary. This is not new, as increased inflation was also first seen as temporary in the mid-1960s. Meanwhile, the Fed did indicate that inflation was higher than expected but never before was there such a large gap between the policy rate and inflation. Apparently, they would rather be too late than too early. The objective is therefore to get inflation up and not down. In this respect, the flirtation with deflation after the Great Financial Crisis changed the job description of a central banker forever. Rising inflation helps solve the debt problem, and in terms of priorities, fighting inflation comes last, after the energy transition, achieving full employment and financial stability. The only reason central bankers are moving now in response to rising inflation is that they do not want to lose the confidence of the general public. Next year, both growth and inflation will come down over the course of the year, and that moment will be used by the Fed to postpone the first rate-hikes in the United States until 2023. Unfortunately, they will have to act again later in the decade because aging, deglobalization, and sustainability are more structural factors that will ensure that inflation will remain above 2 percent this decade. So for the time being, we are not rid of the inflation debate.