For those of us who lived through the 80s, talking about inflation is familiar in one way or another. None of us are surprised by the supermarket's repricing or the constant questioning of prices, even for regularly consumed products. However, for most newer generations, the inflationary phenomenon has barely entered their lives, and for some in developed countries, it might even be an unfamiliar word to their limited vocabulary.
While many governments, central banks and economic schools of thought would like to take credit for the period of low inflation that the world has experienced, upon closer examination, certain circumstances seem evident that caused this period of inflationary peace. This prompts us to think ahead about how viable a return to 'normal' inflation might be.
We consider that some of the major forces behind the low inflation phenomenon over the last 20 years are primarily 1. Economic and commercial globalization, and 2. Technological progress.
Over the past two decades, the significant global economic phenomenon was China. On one hand, the integration of the Chinese consumer into the world had substantial effects on the demand for raw materials and general consumer goods. On the other hand, China would become a global production monster. The competitive low labor costs and incentives from the Chinese government turned this economy into the world's factory. The scale and low labor costs exported deflation to the entire world for more than two decades.
China's economy has not only become the second largest in the world with a GDP of 18 trillion dollars, but there has also been real progress in the economic development of a significant portion of its population. According to the World Bank, poverty levels have reduced in the last 20 years from 88% to less than 1%.
While the above is positive for China's economic history and the pseudo-capitalist model, we believe that much of what allowed China to export cheap goods and, therefore, deflation to the rest of the world has, to a good extent, lost the ability to continue doing so going forward.
On the other hand, the 2020 pandemic significantly exposed the weaknesses of the suppliers for major global consumers. For the United States, the production shutdown in China and resulting shortages critically impacted the American economy as it had not been affected in a long time, from logistics maritime network collapses to insufficiencies in chip production and its impact on various products. The economic incentive for transferring production has limits when they affect people’s well-being and threaten the internal productive chain. Capitalist governments worldwide learned an important lesson during and after the pandemic, as well as during the Russia-Ukraine war, regarding the dangers of over-concentration on suppliers of raw materials or finished products. Similarly, it became clear that underestimating another country's policies is not viable. The Chinese threat over Taiwan becomes even more relevant when the latter concentrates over 80% of the world's chip production, which have the potential to be used as spying tools in phones and computers of 80% of the planet's individuals.
This has led to an anti-globalization movement or reshoring towards developed countries, even if it means giving up the lower costs that favored them when producing in other countries. Although a complete deglobalization is unrealistic, countries, in general, will bring back some of their supply sources to their own country or to closer economies, not necessarily cheaper ones. This will clearly have inflationary consequences, or at least they do not seem like they will be as favorable as the past 20 years.
The other major anti-inflationary variable has been technology.
The technological progress of the last 20 years has not only allowed us to do more things but also to do them cheaper. As tools become more complex, technological progress has not only made them better but also cheaper. Moore's famous law has been fully realized so far, allowing greater computational power at a lower price.
Most notably, the accessibility of personal computers and, especially, smartphones have given rise to new business models and ways of life worldwide. The internet would not be as crucial without smartphones. New business forms emerged through these developments. Amazon, Netflix, UBER, Airbnb are examples of new exploitation forms for old solutions or products that have primarily reduced distribution costs by disintermediating. The significant disintermediation trend has led to a significant price drop over the last 20 years. It is challenging to speculate about future technological advancements; humans have proven to be extraordinarily creative. However, at least today, it seems that for the sources of deflation that were prevalent over the last 20 years, the scope for further drops seems limited. It is true that advancements in Artificial Intelligence and Sustainable Energies can be sources of efficiency and lower future costs, but today, understanding the magnitude of these impacts from the perspective of cost reduction seems challenging. Similarly, understanding opposing inflationary forces, such as measures to prevent global warming and the overexploitation of natural resources, seems difficult.
Adding all in, most investors have taken the recent inflationary period as temporary, incorporating into their expectations a return to 2% inflation, at least for the USA. Discussions regarding the 'normalization' of inflation are about the time it will take to revert to previous levels rather than the current levels themselves. It is difficult to forecast when there are so many opposing forces and especially in the face of such an important potential technological change (Artificial Intelligence) and geopolitical changes.
It seems prudent to us that within the spectrum of future scenarios, one of them should at least consider that the era of 2% inflation is behind us, and the world is entering a new phase of reduced globalization, decreased economic integration, exhaustion of major disintermediation movements, and cost declines. Consequently, higher interest rates, increased cost of money, and a revaluation of the risk premium for investment projects or financial assets.
O wonder! How many goodly creatures are there here! How beauteous mankind is! O brave new world, that has such people in't. William Shakespeare, The Tempest, Act V, Scene I, ll. 203–206
Text: Richard Ramírez
Charts: Fernanda Cruz / Paula Hicks
Comments