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“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens”. John Maynard Keynes
Perspectives can shift a lot in a year!
Governments, central bank economists, and investors have swung from fearing the void created by a self-inflicted recession to fretting about the imbalances of an alarmingly rapid recovery. The global economy could stall due to supply and sourcing constraints, meaning we might have to live with (moderately) higher and less temporary-than-expected inflation.
Ironically, it is in fact the author of the “secular stagnation” theory (Larry Summers) who was among the first, earlier this year, to sound the alarm about the overheating risk posed by the stimulus plans in the context of an already robust recovery. Thus, the risk is that we are adopting the wrong approach, as we have done in the past, by maintaining Keynesian monetary and fiscal measures to support demand in response to a supply crisis.
Inflation: time for a paradigm shift?
Here as well we have a striking shift in perspective relative to the previous decade: after a decade of unsuccessful attempts to reawaken inflation expectations through asset purchase programmes that tended to push asset prices higher, the world’s central banks are now seeking to reconcile support for a messy recovery with the need to normalise their monetary policies in the face of above-target inflation. They are doing all this while de facto having to maintain sustainable public debt. Here we are, back to the central banks’ equation of the 1960s in the era of fiscal dominance. The theory of “Japanification” of the European economy is now but a distant memory!
Beyond the inflation challenges specific to this point in the cycle, economists are now hotly debating a different theory: whether or not structurally deflationary factors are still at play in our economies. For three decades, the triumvirate of ageing, globalisation and digitalisation has translated into about 1% inflation in Europe, exacerbated by the individualisation of working conditions and by oversaving and low investment. While some of these factors are expected to last (chiefly digital and demographics), it is possible that the globalisation factor and low-wage competition could recede.
New markers to consider
As inflation has strong political, social, and emotional dimensions, thanks to the collective memory of the European and Latin American countries that were scarred for life by hyperinflation, it makes a lot of sense that renewed price pressure would lead to overly fearful reactions to the return of uncontrolled inflation. The danger would therefore be to declare that inflation has definitively and sustainably returned, a theory to which we do not subscribe.
The most likely scenario is rather that this surge will gradually subside in 2022, and that inflation will stabilise at a higher level than in the previous decade. Ultimately, it may well be that inflation will bear the hallmarks of the social preferences and political constraints of this new decade: a keener awareness of both the unsustainability of inequality and climate change, in addition to the need to ease debt ratios without resorting to austerity policies. This equation would likely be favourable to a slightly higher inflation regime.
The about-face is stunning here as well: low inflation policies are now seen as inegalitarian when asset prices climb, where inflation was seen as the scourge of the purchasing power of the middle class, with François Mitterrand writing in 1978 that inflation is “a tax on the poor”. This is because wages have barely risen in Europe, for now, as opposed to the United States. It is therefore not clear that everyone wants inflation to come back, although it is still the best way for governments to successfully address excessive public debt.
So, it is not a new world that is emerging, but rather a new balance that needs to be found, one that is characterised by an acceleration of the trends in play before the pandemic. There is, however, one unknown that could derail the equation: the trajectory of the Chinese economy, which has been the lifeblood of global growth for the last decade and will likely be affected by the restructuring of the real estate sector for the next two years.
The central banks will therefore have to walk a tightrope between economic support, inflation control, and debt containment. Responses will vary between the western economies, which are tentatively normalising; China, which must deleverage its real estate sector; and other emerging countries, which have been the first to raise their rates. This monetary divergence is key to analysing the currency environment next year.
Pricing power: a tool against rising prices
These inflationary tensions, whether lasting or temporary, pose many challenges for companies. However, for now, margin levels in various sectors of the economy are almost shamelessly resilient as we approach the end of the year. In the face of rising energy costs and higher wages in the United States, companies are currently enjoying significant pricing power; this includes sectors characterised by supply/demand imbalances and high value-added sectors where demand is relatively inelastic to price changes. It is clear, however, that it is easier to absorb these cost increases in a strong growth year than in a more normal year, and this will therefore be a key issue for expected returns in the coming years.
This is the topic we will cover in this Global Outlook, which seeks as much to shed factual light on the various current causes of this renewed inflation, as to sketch a scenario for the coming year, and, lastly, to identify the implications for central banks, currencies and equity investors.
*Editorial of the Indosuez Global Outlook release of 17/11/2021
December 15, 2021