Road to a Sustained, Above Trend Inflation
- The initial reaction to Covid-19 was to take every precaution to stop its spread. This resulted in the shutdown of Wuhan, where the virus was first identified. This led to the shutting down of countries’ borders around the world. Transportation by sea, air, train and trucks were all impacted. Because China is an essential part of the global supply chain, the cumulative effect was a supply shock of goods globally. Different parts of the well-oiled, efficient, and just-in-time supply and value chain broke down. Further, commodity production, supply, and delivery were also significantly upended.
- With social distancing and the absence of a vaccine, service sectors came to a virtual halt as everyone was sheltering-in-place to avoid catching the contagious and deadly virus. Yet, with fiscal transfers to serve as a safety net, households were flush with free money, and the only place to spend was buying goods online, which added more pressure to the supply chain. With increasing demand and shrinking supply, prices rose. (The Fed was thinking that the demand/supply shock would heal quickly as the world economy opened and thus believed that inflation was initially transitory.)
- As more were vaccinated and the U.S. began to reopen, people slowly turned from purchasing goods to buying services (which represents 2/3rd of the U.S. economy). However, this was happening at a time of significant labor shortage (early retirement, delay re-entry due to fiscal transfer, extended unemployment benefits, lack of childcare, long-Covid, etc.) which led to a rise in service worker wages. Further, with still above trend demand and a delay in the service sector fully recovering, prices rose.
- Although economies began to recover from Covid-shocks, China’s zero-Covid policies continued to disrupt and delay supply chain recovery as important industry and technology towns were forced to close down from time-to-time due to an insurgence of local Covid cases. Then, in February, Russia invaded Ukraine. This not only created a significant humanitarian crisis, it also resulted in a crisis for global energy, minerals, fertilizers and agricultural commodities; and thus, prices spiked.
- Finally, weather pattern changes are likely to have a more severe impact on food production and agricultural products. This further contributes to inflation and inflation anxiety.
- All this means that we are expecting more elevated prices for longer periods which have financial, policy and political consequences (especially in poor countries and developing economies).
For our complete commentary, please click here.