The chart above illustrates the idea behind the quantity of money theory – higher rates of growth in money supply have corresponded to higher rates of inflation, especially when growth in money supply tops 10% YoY. The chart doesn’t capture the latest developments in inflation with the June CPI print hitting 5.4% YoY and 0.9% MoM. The Fed have long been touting ‘transitory’ inflation arguments, with one of the former arguments being base effects. Given we’ve had 4 consecutive months of increases larger than 0.5% MoM, it’s clear that inflation is down to much more than base effects. CPI MoM increases of 0.9% aren’t common, there have only been 3 instances since the 1970s. The other transitory inflation arguments are the reopening of the economy and supply bottlenecks. There is some truth in both of these – air fares, hotels and eating out were among the bigger contributors to the inflation print last time, but how can anyone know how long this may last? US household wealth recently hit a record $137tn through government support, rising asset prices and wage growth. Can this spending not continue for years if asset prices and wages continue to rise? US businesses have complained about lack of workers for the last few months – jobs openings are at their highest since records began in 2000. One of the reasons behind this is that employment benefits continue in most states until September, so we’ll get a better outlook on employment towards the end of the year. In the meantime, employers have had to resort to wage increases to attract workers. Wage increases tend to be sticky and put money in the hands of people who spend. Despite this, the U6 unemployment rate in the US continues to be elevated at 9.8%. This number is dominating the Fed’s policy thinking at the moment and pushes for dovish monetary policy despite the surge in inflation.

So will we get higher persistent inflation or will it be transitory? It’s very difficult to predict. Economists and central bankers have struggled for decades trying to accurately forecast inflation figures, but everything is lined up for higher inflation at some point. Critically, the Fed have signalled that they won’t raise rates until they have seen consistent inflation above 2%. In the entire history of the Fed, this has not happened before. They used to tighten in advance of inflation to prevent it surging and risk losing control. Policy was always determined by expected inflation more than past inflation. If central banks are actively encouraging higher inflation, that helps immensely with prompting its return.

Last quarter, the word ‘inflation’ cropped up more than 3,600 times in earnings calls across the World Index’s 1,557 stocks. This is the highest in more than two decades. One of the key concerns being echoed is the fragmentation in supply chains and the bottlenecks that persist. Once again there are more than 30 container ships anchored off LA waiting to berth. This is being driven by a shortage of trucks and drivers going to pick up and transport the cargo. Container rates have skyrocketed – a container from China to Europe used to cost $2000, it’s now $14,000; a container from China to the US west coast that used to cost $3,000 now costs nearly $7,000. Of course all these costs are squeezing businesses in the US who must make the decision to accept a large squeeze on their profit margins or pass the costs on. We know some costs are being passed on, that’s evident from the inflation figures that are among the highest since 1980. The global chip shortage is causing production issues in electronic goods and cars. The chairman of Daimler estimated that the shortage could last through 2022 possibly into 2023. The general message being conveyed by large company CEOs is that these pressures aren’t going to ease until later next year. 

There are strong theories that changes in trade, mostly with respect to China, may lift some of the disinflationary pressures we’ve seen over the last 30 years. This was a view aired by Greenspan in 2006 who believed that China’s cheap labour supply would be over before 2030 and that would allow inflation to return. The same arguments have been made by economists Charles Goodhart and Manoj Pradhan. Over the last 40 years China’s economic boom has lifted millions out of poverty and seen wages rise dramatically. In 1980, 80% of China’s population was rural compared to 40% today. Europe’s rural population is 28% and the USA’s is 23%. As workers move from the countryside to cities, companies expand and make use of cheap labour. This has the effect of making China the world’s cheap global factory. However, at some point you run out of labour to draw from the countryside and companies have to compete for existing labour. That puts upward pressure on wages and upward pressure on the prices of goods they manufacture. We have already reached this point in China. Since 2000, China’s real wages have been increasing by 10-15% each year and has only recently come off slightly to 7% growth. As the Chinese become wealthier, they become bigger consumers and demand higher wages, both which will pressure prices higher over the long term. The only way to continue the deflationary trends of the last 40 years would be to shift the world’s cheap factory elsewhere. India and Africa seem the obvious contenders but both have issues that render the transformation unlikely. At least, they will not fulfil that role close to the level that China has managed. 

The larger forces at play through the Fed, supply bottlenecks and China suggest that inflation could be more persistent throughout this coming decade. Central Banks globally have benefitted from 4 decades of disinflationary forces and as a result, may now be overestimating their ability to control it. If supply chain disruption or China’s growth beyond manufacturing goods at rock bottom prices causes prices to rise, the cure for it is to fix the supply chains or move manufacturing to new countries with cheaper labour costs. Raising rates will stymmie demand but it doesn’t fix the inherent issues driving inflation. I think it’s certainly possible that the Fed and other Central Banks get a bit of a shock when they realise that their tools for fighting inflation aren’t as sharp as they had hoped. Let’s not forget the tools that failed through the 1970s – rate hikes, the infamous ‘Whip Inflation Now’ Government scheme that appealed to the people to stop spending. There were wage and price controls. None of these worked until the last tool in the box was the giant sledgehammer used by Paul Volcker that involved raising rates to the highest level ‘since the birth of Jesus Christ’.