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Transitory or Permanent? The roots of the post-pandemic inflation

This is not the first time when we've got a heated debate over the causality of inflation. In fact, the question whether inflation is caused by demand or supply factors comes up every time it happens.

The most prominent example in the history of monetary economics comes from the Bullionist Controversy. In 1797, the period of French Revolutionary Wars, a rumor spread around Britons of a coming invasion on their land. The immediate consequence of that gossip was a widespread panic. People had started withdrawing their gold deposits from the British banks, and the Bank of England was left with no other choice than to suspend the gold convertibility. Inflation followed.

In the first half of the 19th century, there was no price index that economists could use to estimate the level of general price inflation. There were yet signals that the whole monetary system was out of balance. The price of gold bullion rose up, prices of agricultural products went significantly up, and on top of that, exchange rates fell. What could be the reason of these disturbances if not the reckless policy of the BoE and overissue of paper notes? This was the position of the so-called Bullionists represented by inter allia David Ricardo.

On the other side of the spectrum, there were men that defended the Bank of England and their explanations were plausible too. What if expensive food was caused by poor harvests and continental blockade imposed on the British. The falling exchange rate was also justifiable as, in times of Napoleonic Wars, the British had to pay subsidies to their allies, which created a situation that a century later came to be known as a transfer problem. Each side of the Bullionist Controversy had its valid arguments1.

Just as in the times of the bullionist controversy, right now we are in the middle of the "great inflation debate". Do reserves matter? Do reserves create inflation? I doubt it, and below you can find out why I think so.

Are central banks to blame?

Modern central banks conduct monetary policy by essentially using three tactics: controlling the bank rate, open market operations, and talking2. This is of course an oversimplification, as we omit a few other things that make a monetary policy, like setting the reserve requirement ratio or collateral frameworks. Nevertheless, it suffices to focus only on these three actions to determine whether the FED or ECB create inflation, as these are the tools that have the most evident impact on the markets.

Let's start with asset purchases, as it is the most controversial and paradoxically the easiest one to work out. The reason for this is that we already have 20 years of data on the infamous quantitative easing, and so the verdict is simple. Quantitative easing does not ease and does not affect inflation. QE may have an impact on inflation expectations, something that (for no obvious reason) economists have an obsession about3. It may also have other effects and spillovers, yet all of that is irrelevant in investigation of current inflationary forces.

All it takes to realize, that the expansion of a CB balance sheet in today's environment is not associated with inflation, is to look at the graph above. Since the GFC, ECB would sometimes reach the 2% inflation target, if they were lucky. This all happened in the period when the European Central Bank pumped up their balance sheet by over 5 trillion EUR. Japan did exact the same thing but started a little earlier in 2001 and could not generate inflation in 20 years.

Inflation doesn't show up only in the CPI numbers, it also shows up in the bond market. What is the response of 10-year treasury yield to the central bank asset purchasing? Nothing. Bond yields have been just continuing the downward trend and totally ignored central bank "unconventional policy". If anything, over the years, QE has helped to push bond yields lower and not higher.

If we look at the recent developments, bonds even tell something about 2021 price increases, and that's: "no need to panic". Dispersion between the 10-year bond yields and CPI rates (gap between orange and blue lines in plots above) in 2021 say, that at this point, the inflation is at most transitory.

If QE is useless, then maybe CB's ultra-low interest rates contributed to the 'inflation'. This sounds plausible, however for decreased rates to be expansionary, we need also moves further in the channel of the interest rate transition mechanism.

Since Q4 2019, we don't see much lending going on, neither in Europe nor in the US. There was a spike just when the lockdowns hit the global economy, but these were revolver overdrafts, parallel to the GFC. Bank clients were maxing out their credit lines, because they were in a panic mode, not because of positive investment prospects. When lockdowns had eased, recovery started, though, not for lending. Loan growth has been, on average, declining despite ZIRP.

There can't be any prospects of monetary inflation in the near future without a significant increase in lending and spending. And spending isn't that optimistic, either. In Germany, retail turnover fell down 2.5% m/m in September and  dropped further 0.3% in October. It seems inflation is nowhere to see but in the CPI numbers.

As for the third 'tool' of central banks, namely, forward guidance aka managing expectation aka talking, central bankers have been trying to persuade the whole economy into more inflationary behavior for many years now with very little success. Sure, in the short-term, some markets react to CB speeches and announcements, but when it comes to inflation, CB just can't talk people into spending more or expanding real investments. Corporations sit on huge cash holdings, and people just don't spend that much.

The real cause of 'inflation'

If monetary policy doesn't generate higher inflation, then how did we get high CPI growth? It is undeniable that all widely used price indices have spiked up this year. If it's not money, then it must be the real economy. Everyone who follows the financial media knows that supply bottlenecks definitely have had an impact on recently rising prices. The question is to what extent production, transportation and warehouse disruptions contributed to the new market disequilibrium. Changes in energy prices can help us to illustrate the magnitude of shocks as well as the tight dependency of the economy on the raw material markets.

Among all the commodity types, the energy sector is obviously the most important one. Most economies run primarily on petroleum and natural gas. In the US, these two energy sources represent about 70% of all energy consumption, and the same goes for most of the other developed countries that are not nuclear-focused. Not surprisingly, any moves in the price of crude oil push inflation numbers in the same direction.

Over the last 12 months, West Texas Intermediate (American crude) and Brent (European crude) futures went up over 55%. In the same period, the price of natural gas increased by 70% and coal went up 117% y/y. Comparing these growth rates to inflation rates, we have, for the same period, PPI at 16.3%, CPI at 6.3% and core CPI at 4.6%.

Producers get hit the most as they are most sensitive to higher energy prices. Machinery exploitation, transportation, warehousing and material costs all need some kind of energy to power a production process. Though, not all costs will be transferred to the final client. Generally, prices tend to be sticky, especially, when it comes to costs of energy sources, which are relatively volatile and mean-reverting. Producers want to be competitive, and so they will embrace lower margins just a bit to end up with a bigger market share. Hence, the CPI rate is over two times lower than the PPI rate.

To deconstruct the energy and CPI relationship even more, we can look at the CPI that excludes very volatile constituents, which are food and energy. Core CPI takes into account neither oil prices nor gas prices, yet it has risen over two times the FED inflation target. The reason for this development is twofold. First, even though producers are not very eager to ramp up prices, they sometimes have no other option but to do so. Hence, higher energy prices feed into commodities and services that are generally less sensitive to energy shocks. The second reason is that energy inflation is only one piece of the puzzle, and we also have to take into account other non-energy commodities and logistics.

The coronavirus pandemic and global lockdowns have set off a highly volatile environment in commodities market that some refer to as "commodity supercycle". To pick just one, in 2020-2021, daily volatility of copper went from 35% pre-2020 to 72%. A similar thing happened to lumber, palladium, platinum, iron ore, lithium, and most importantly semiconductors.

Computer chips are important because they generate computing power that is used in automation processes and high-tech products. The most prominent example is the automotive industry, which now experiences a slack that has been driven mainly by semiconductor supply problems.

The October new vehicle CPI year-over-year growth reached 9.8%, yet, since January, US total vehicle sales numbers have plumed by 22%. Any type of decrease in expenditure signals a deflationary environment, not money inflation. Furthermore, sales drop is much more severe than auto inflation, so this means that the demand side reaction is not all that great.

The effect of semiconductor prices on the auto industry is one example, and there are other important materials, which price have spiked in 2021. Notice how in the last 20 years, PPI and CPI followed industrial materials index. Moreover, when it comes to logistics, container freight prices are still in the $10,000 area, over three-times more expensive than a year ago. Warehousing? Lots of problems there too. In the last six years the average of warehousing component in the headline PPI was 177.7, as of October it is at 135.4 and there are lots of stories how there is a fight for warehousing space.

Transitory or not?

The ultimate question is, obviously, whether the inflation will stay. Everything brought up above suggest that the inflation is indeed transitory. The transition will last for as long as we have energy and supply chain disruptions, so it is not clear whether it will be six more months or two years, though.

Latest developments show that the inflation is indeed easing off. Observing CPI growth numbers on the month-to-month basis shows that the September and October was not as scary as the first-half of 2021. It is important to remember that in 2020, the global economy was in a massive dip. Therefore, comparing current inflation levels to the levels of last year economic depression does not show the whole picture very accurately.

It is hard to foresee when the good old disinflation will come back. As far as supply chains are concerned, on one hand, we see a drop in some freight prices. On the other hand, warehouse capacity still severely expensive. American oil and gas prices slowly go down, but there are still problems in the Europe as the price of natural gas is still at all-time high.

Globally, semiconductor market haven't eased yet. There is, however, a lot of optimism when it comes to the microchips. Lisa Su, who is the CEO of AMD, notices that as the new plant construction goes very smoothly, the situation in 2022 should be much better. Moreover, IDC reports that semiconductor market may reach overcapacity in 2023. Cheap microchips together with lower energy prices, that have already started falling, will eventually push the other parts of the economy to disinflate and end this episode of the post-covid inflation.

A modern Thornton view

The one who was the sanest person in the whole Bullionist Controversy, was probably Henry Thornton. The London-based banker was somewhere between the two opposing parties, as he agreed with most arguments of both sides, but disagreed on the central argument of the aniti-Bullionists - the real bills doctrine. At the time, the real bills doctrine was a wide-believed conviction developed by Adam Smith claiming that lending against real productive output (i.e. good short-term collateral) will never create inflation. The doctrine has its flaws4, so as the thinking that the central bank controls inflation or that QE creates money is completely flawed.

Today, the best we can do in assessing the monetary situation is to, just like Thornton, accept all that is self-evident, i.e. supply-chain bottlenecks contribution to the price increases. And follow with a rejection of all things that are widely believed but lack the evidence and logic given all relevant data.

Transitory? Correct. Low long will take the transition? Nobody really knows.


[1]: More on the Bullionist Controversy: "Highlights of The Bullionist Controversy" by David Laidler (2000).

[2]: These 'tactics' are mainly the things central bankers do to influence inflation expectations, that can then have an impact on the real inflation. For a more sophisticated breakdown of the overall implementation of monetary policy, see a book "Monetary Policy Operations and the Financial System" by Bindseil (2014). For a quick view of how the mainstream econ sees the monetary transmission mechanism, look at this schematic.

[3]: It is not clear why inflation expectations play such a big role in monetary economics, because this hypothesis, (that inflation expectations move the real inflation,) has no real empirical foundations. The assumption of inflation expectations is just there as a mico-fundation of very complicated macro models that economist use to forecast. Jeff Snider wrote a good article on Rudd's paper that goes deep into this matter.

[4]: Flaws of the real bills doctrine: differentiation between productive and speculative bills (collateral); the money supply is based on the nominal value of the real output and not just the real output (Thornton's main point); exacerbation of the business cycle (higher prosperity in good times and deeper recessions in bad times).