Inflation may be more about the destination than the peak

Inflation has been hotly debated since the pandemic started. The confluence of supply shocks, extraordinarily stimulatory fiscal and monetary policies and powerful geopolitical developments has led to highly unusual inflation outcomes by historical standards. To get a better understanding of the cyclical and secular trends driving inflation we recently organized the second edition of the Robeco Annual Inflation Day.

The discussion was focused on four topics:

1. Supply chain disruptions

2. The interplay between wages and inflation

3. Globalization and deglobalization

4. Inflationary effects from the energy transition
   

We invited external specialists to take us through these topics in more detail.¹ This note summarizes our key takeaways. The overall conclusion is that while headline inflation in the US might have peaked, it might not yet have done so in the Eurozone and the UK. Moreover, the descent from the peak may be slow and could initially look more like plateauing, thus keeping central banks concerned about a persistent feedthrough into higher inflation expectations and wages. This also implies that inflation uncertainty, especially about where inflation will settle, is likely to remain elevated in the coming quarters.

Those interested in our views on how to navigate fixed income markets amid elevated inflation and the associated uncertainty are invited to read our latest Central Bank Watcher or listen to our recent podcast on the topic. In mid-June we will also publish our new Global Macro Quarterly Outlook, in which we will outline how inflation and central bank policies impact our portfolio decisions on duration, FX and fixed income asset allocation. So stay tuned!

Disruptions to global supply chains due to the pandemic have been a source of upward pressure on inflation, especially goods inflation, over the past two years. We note from the discussion that supply chain disruptions peaked in October 2021 but that the easing of bottlenecks has stalled since March 2022. The key reasons for this are a decline in Chinese semiconductor production (-12% month-on-month in March) due to Covid restrictions, and European car production suffering from a shortage of wire harnesses due to the war in Ukraine. It is likely that the war and the sanctions on Russia, by restraining the supply of essential inputs such as fertilizers and grain, will amplify the surge in global food price inflation.

One area where progress has continued is port congestion. Long queues of ships were building at ports such as Los Angeles and Long Beach between June and October 2021. These queues are now almost back to normal. Practical steps such as creating space by removing (empty) containers from the harbor, financial incentives to work on weekends, and determining the place in the queue when ships leave their port of origin have been helpful in reducing the congestion. Another positive point worth mentioning is the limited impact so far of Covid restrictions on the shipment of Chinese exports. While the number of outbound ships from the port of Shanghai is down, other Chinese ports have been able to take over. But there remains a high degree of imbalance in demand for Asian goods compared to Asian and Chinese demand for goods produced outside of Asia. This imbalance accounts for the ongoing scarcity in containers for shipments out of Asia, and helps explain still-elevated container freight rates.

Car prices have been an important source of inflation, as evident from the rise in the prices of new and used vehicles, and in the cost of car rental and insurance. It is therefore encouraging that auto production plans in the US have recently expanded again, reaching pre-pandemic levels and diverging from the ongoing interruptions that are haunting European producers.

Shortages of semiconductors have been a major bottleneck in the production of many goods. These shortages continue, but semiconductor production has accelerated and is now 19% above the level that would have been expected based on pre-pandemic trend growth. As investments in the chip sector continue – we’ve seen a 55% increase in capex since the pandemic – it’s possible that there could be an over-supply of computer chips by 2023.

Wage growth in the US (approximately 4.7%) is exceeding that in the Eurozone (circa 2%). Part of this difference can be explained by the policy response to the closure of businesses at the start of the pandemic. US policy focused on income support, while European plans were aimed at job preservation. In the US, 22 million workers were fired and later re-hired, while in Europe relatively few people lost their jobs, thanks to furlough schemes. As it is easier to obtain a wage increase when entering a new job rather than in an existing job, the process of re-hiring amid growing labor shortages resulted in high wage rises in the US. In that sense the labor market churn rate at least partially explains wage-growth differentials around the world. Note that in the US – and in the UK, in part due to Brexit – the supply of labor has also been dampened, which relates to early retirement and lingering pandemic effects (preference for part-time employment, for example).

It is difficult at this stage to judge how significant the risk of a wage-price spiral is, but we take the view that such risk appears more substantial in the US than in the Eurozone. The Eurozone has a long history of relatively subdued wage growth and inflation, which could help limit the pace at which wage demands rise from here onwards. Looking at incoming pay settlements, Eurozone wage growth is likely to stay within the range of the past 20 years. The situation is somewhat different in the US and UK, where inflation and wage growth has been more volatile over the past decade. That said, elevated headline inflation in the Eurozone has started to feed into higher inflation expectations, including that of consumers. The risk of higher inflation expectations feeding through into persistently higher wage growth should therefore not be disregarded. It seems hawkish ECB governors are increasingly aware of this.

Globalization of value chains and the integration of China into the world economy have acted as a restraining force on goods price inflation over the past few decades. A scenario of ‘slowbalization’, or slower globalization, and more hypothetically deglobalization could be a reason to expect somewhat higher future inflation. It’s true that the pandemic revealed many weaknesses and important dependencies in the global supply chain for a range of goods, and ever since 2020, many pundits have been expecting a sharp trend toward the onshoring of production. However, thus far there seems to be little sign of a broad process of deglobalization. For example, while the Chinese market share in the consumption of US manufactured goods has been declining since 2018, other low or lower-wage countries (e.g. Vietnam) have taken over China’s share. Indeed, global trade volumes remain high.

It is also important to note that the dampening effect of globalization on inflation had already been waning. From 1998 to 2008 this impact was estimated to be -0.5pp p.a., versus -0.25pp for the period 2009 to 2019. Finally, there is little data supporting the idea of re-shoring (bringing back production) as a solution to deal with supply chain disruptions. Other strategies, such as increasing inventories and diversifying supply chains, appear to be more popular.

When thinking about the overall inflationary effects from the energy transition to reach net-zero GHG emissions, ECB Executive Board member Schnabel argues that it is helpful to distinguish between three shocks. These are ‘climateflation’, i.e. cost increases due to climate change itself (such as food price increases caused by severe weather events); ‘greenflation’, i.e. inflation due to, for example, increases in the price of commodities used in green technologies, and ‘fossilflation’, which is the legacy cost of the dependency on fossil energy sources.

On the last-mentioned shock, it was discussed that the ramp-up of capex in green energy has been too slow in comparison with the disinvestments from fossil energy over the past five years. A further delay in green capex – the EU is now discussing a EUR 200 billion renewable energy investment package for the period 2022-2030 – is thus one of the channels via which the energy transition could contribute to higher future inflation.

Carbon taxes could be a relatively efficient way to stimulate the transition in demand away from fossil fuels and towards green energy. Our discussion highlighted that effective carbon taxation would add approximately 0.25% p.a. to US inflation and 0.1% to German inflation for a period of at least three years. Emission caps and a prescribed minimum percentage of renewable energy sources would be less effective in bringing about such a transition – and would be more inflationary. Other channels through which the energy transition could be inflationary include a potential wage-price spiral resulting from scarcity of qualified staff to execute the transition process.

Footnote

¹ We would like to thank Arend Kapteyn (UBS), Greg Fusezi (JP Morgan), Yulia Zhestkova and Daan Struyven (Goldman Sachs) for sharing their views at the Inflation Day.