Interest rate changes of high speed and big magnitude may be precursors to structural changes altering the face of financial markets. A lasting change in interest rates hinges on the question of how stubborn inflation will turn out to be.
Even if large deflationary trends are still underway, such as continued technological progress and digitalization, there are four compelling reasons to believe that inflation will not retreat as quickly as investors hope.
Risk of supply side shocks linger on
After Covid-related lockdowns caused the first economic supply side shock since the 1980s, the Russia-Ukraine war continues with no resolution in sight, fuelling severe disruptions to energy supply and prices.
As long as this situation continues and alternative energy sources remain scarce, it will be difficult for prices of manufactured goods and other commodities to come down from elevated levels. That is, unless there is a broad-based reduction in demand plunging the global economy into a recession.
In addition, tensions between the US and China around Taiwan have flared up, threatening global trade in general, and semi-conductor supply in particular.
Finally, the transition to a green economy harbours the risk of more supply side shocks as an economic carbon-zero transformation requires high amounts of metals, energy, and other commodities.
Due to lacking infrastructure and currently low inventory levels, it is doubtful if the volumes needed for a frictionless transition can be provided by commodity producers in the short to medium term.
Economic overstimulation fuels wage growth
Due to the pandemic-related overstimulation of many economies, wages have started to rise, gradually increasing their share of national income. Therefore, the pressure on corporations to pass rising costs on to the consumer to maintain margins has risen.
Not all companies will succeed in this endeavour, but essential goods and services are likely to have higher price tags as the consumer is less inclined or able to cut spending on those.
Once the inflationary input cost-wages-consumer price circle has closed, inflation has formally established itself in the system, leading to an elevated price level over the longer run.
Near-shoring increases production costs
Since the global financial crisis (GFC), the world has entered a period of “slowbalization”, or stagnant global trade, measured as a share of global GDP. This is a trend that rose to renewed popularity under the Trump administration.
Back in 2008 / 2009, the main catalyst was global banks being pushed to deleverage for the sake of systemic stability. Now, persistent geopolitical risks and crises have increased awareness that international production hubs and far-away trade dependencies may disrupt longwinded supply chains, severely affecting business results. This has been driving the momentum of bringing production facilities closer to home.
However, near-shoring leads to higher production costs and, ultimately, higher consumer prices as producers are shifting away from lowest price producers for the sake of supply chain and production stability.
Inflation is a remedy to ballooning government debt
Rising indebtedness of governments around the globe limits the ability of central banks to fight inflation by way of rate hikes. Policy tightening, which usually translates into higher yields at the long end of the bond curve, leads to higher debt servicing costs, making it more expensive for governments to issue new debt.
Also, default risks cannot be ruled out as has been revealed by the European Central Bank’s rate hike in July 2022 of 50 basis points, the first in 11 years, which triggered substantial spread widening between yields of Italian vs. German government debt, for example.
Moreover, inflation might prove a practical way to deal with rising governmental debt burdens, as the real value of outstanding government debt falls when inflation is on the rise.
Even though this circumstance won’t prevent policy normalization from happening, since exorbitant inflation would disincentivize lenders to grant loans, ‘measured’ inflation could still turn out to be a welcome solution to the huge piles of global government debt.
Sven Schubert is a senior investment strategist at Vontobel. The views expressed above should not be taken as investment advice.