The Great Erosion
Head of Macro Analysis
Summary: Inflation is anything but transitory. At its March meeting, the ECB released its latest staff macroeconomic projections. All scenarios show a decrease in CPI.
Inflation is anything but transitory. At its March meeting, the European Central Bank (ECB) released its latest staff macroeconomic projections. In all scenarios, the euro area Consumer Price Index (CPI) is expected to decrease close to 2 percent year on year in 2023 (see Chart 1). This is wishful thinking; it currently stands at 5.8 percent year on year (the latest figure for February). It’s not just oil and energy prices that are rising fast anymore. Food, non-energy industrial goods and services are all accelerating at more than 2 percent; inflation is now broad-based. This is before we see the full consequences of the Ukraine war on the inflation dynamics. Our baseline is that the war will add at least one percentage point to the average euro area CPI this year. We have discovered with the conflict that Ukraine is a hub of international trade; for instance, it produces 70 percent of global neon gas exports. This purified version of gas is crucial to the semiconductor industry and we need it for many daily life products such as smartphones, medical devices and household appliances. But war is not the only issue on the table.
Supply chains disruptions will last at least until 2023
Supply chain disruptions are increasing. There was no real improvement before the war and now, things are getting worse; this is the biggest trend unfolding in front of us. On top of closed and sanctioned Russian mineral exports, several countries are limiting their exports of basic goods. On March 14, Argentina shut down its soya and soy oil exports (41 percent and 48 percent of global exports respectively) for an unlimited period. At the same time, Indonesia tightened export curbs on palm oil—the world’s most widely used vegetable oil and used in several food products. Many countries are following the same path, including Serbia, Ukraine, Egypt, Algeria and Bulgaria. Others are still dealing with the pandemic. Shenzhen, China’s enormous manufacturing hub and port city, went into lockdown in mid-March. Shenzhen is home to some of China’s most prominent companies, including Tencent Holding, operator of the popular WeChat message service, and the electric car brand BYD Auto. It’s also the fourth largest port in the world by volume with the transit of 15 percent of Chinese exports. It could take six to eight weeks to clear the backlog; a sustained improvement in international shipping is only expected in 2023 onwards when new containers will arrive in the market. Port congestion is not the only driver of inflationary pressures. In the past few months, we have mentioned several times that the European green transition is fundamentally an inflationary shock for the European households and companies (see our Q1 outlook). Instead of the COP26 resulting in a phasing down of coal, the sad reality is that coal and gas are growing. Hopefully, the Ukraine war will lead to a rethink of the Germany and Belgium nuclear phase-out, but it will take at least 7 to 10 years before new nuclear power stations are operational. In the interim, inflation will remain a headache.
History doesn't repeat itself, but it rhymes
In our view, comparing today’s inflation with the 1970s or the 1973 oil crisis does not make sense. There are at least two main differences: the Covid-19 policy mix in the developed world was out of all proportion to what we have known in the past, and there’s no price-wage loop in most euro area countries. In the 1970s, wages were automatically indexed to inflation. This is not the case anymore, with a few exceptions (in Cyprus, Malta, Luxemburg and Belgium, indexation is based on core CPI). So far, wage negotiations in euro area countries have led to an average increase below inflation (less than 1 percent in Italy and between 2 and 3 percent in the Netherlands, Austria and Germany, for instance); this is not the stagflation we experienced in the 1970s. Some economists call this new period the Lowflation. We call it the Great Erosion: erosion of purchasing power, corporate margins and growth due to the explosion of supply costs at the global level. This is the fifth regime shift over the past twenty years: the Great Moderation, the housing bubble, the Secular Stagnation and the Taper Tantrum were the other four. The main question now is who will bear most of the cost. Our bet? Corporate margins. What could prevent this? Basically, we need productivity gains. Unfortunately, we don’t see strong evidence in the data of sustained productivity gains from remote work, and whether the green transition will have a net positive or negative effect on productivity is debatable.
The inflation/recession dilemma
All the central banks are officially committed to fighting inflation—this is obvious. The hawks clearly took control of the ECB narrative at the March meeting, but some central banks are certainly more committed than others. We suspect they could take a sustained 3-4 percent annual inflation rate rather than engineering a recession to get them lower. This means they could bluff about it staying hawkish in words rather than deeds. This is certainly more the case for the US Federal Reserve than for the ECB. Don’t forget inflation above the last 20-year average has a positive impact on the debt burden too; this is an added bonus. After the Global Financial Crisis of 2007-08, many countries tried the conventional way to reduce debt—meaning austerity and structural reform. It has failed and now it’s time to adopt a more unconventional approach: inflation, repression and, in a few cases, default. This will have major implications in terms of investment (outweigh commodities and real estate amongst other options) but also fiscal policy with increased income redistribution for the lowest quintile of households. Not everyone is prepared for what is coming: a prolonged period of high inflation before it drops.
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