What is driving the inflation spike and how are central banks playing their game wrong?
China: a “control by a single country of global inflation”
In “Monetary policy in the grip of a pincer movement», Claudio Borio et al. discuss how the effects of globalization, in particular China’s entry into the World Trade Organization (WTO) and the collapse of the Soviet Union, exerted structural disinflationary pressure that prevailed on drivers of domestic inflation in advanced economies:
“A likely candidate is globalization, particularly the entry into the trading system of former communist countries and many emerging market economies that have liberalized their markets – countries that, moreover, have tended to resist exchange rate appreciation.As argued and documented in more detail elsewhere (Borio (2017)), the entry and greater importance of these producers has likely weakened the pricing power of firms and, more importantly, of the labor force. labor markets, making markets more contestable.During the process of cost convergence, this would translate into persistent disinflationary winds, especially in advanced economies, where wages are higher. Taken together, developments in the real economy may have exerted persistent downward pressure on inflation, perhaps overriding the cyclical influence of aggregate demand.
Monetary policy is effective against cyclical failures – such as market instability after financial crises – but ineffective against structural changes. However, major monetary authorities nonetheless interpreted China’s structural disinflationary pressures and the integration of former Soviet states into global value chains (GVCs) – a long-term structural change – as no different from weak cyclical resulting from short-term disturbances.
This has contributed to the asymmetric policy response from central banks which is easing aggressively but tightening tentatively, as long as inflation remains below target, regardless of structural versus cyclical causes. Like Borio et al. to write:
“The second factor is an asymmetric policy response to successive financial and economic cycles in the context of disinflationary headwinds linked to globalization. In particular, asymmetric responses have been evidenced around the financial boom and bust of the 1980s-1990s and that surrounding the GFC. As long as inflation remained low and stable, central banks had no incentive to tighten policy during the financial booms that preceded financial strains in both cases. But there was a strong incentive to react aggressively and persistently to fight the crisis and avert any threat of deflation.
In this political context, a structural factor of disinflation interpreted as a cyclical shortfall demanded an aggressive monetary response, as well as a timid and belated policy tightening thereafter. Sustained low interest rates have boosted low-productivity sectors like real estate and accelerated the misallocation of resources (malinvestment) and contributed to the proliferation of “zombie” businesses.
Indeed, the confusing structural and cyclical drivers of inflation by central banks have made China a crucial catalyst for quantitative easing (QE), although the “single country control of global inflation” subsequently attracted more market attention.
Chinese producers pass on higher prices downstream amid soaring costs.
After acting as “shock absorbers of global inflation” for nearly two decades, Chinese producers have faced a perfect storm of margin squeeze amid simultaneous supply bottlenecks and a rebound in demand in the first half of 2021. As former People’s Bank of China (PBOC) official and Bloomberg economist David Qu observed, volatility in global commodities, from crude and iron ore to copper – together representing 70% of China’s Producer Price Index (PPI) moves – pushed input costs to record highs.
Such a spike in costs afterwards discussed policy responses aimed at curbing price growth. Macro investors acknowledge a steady rise in U.S. import prices on goods from China, though many disagree on the effectiveness of price controls or whether a rebound in dollar propelled by a hawkish response from the US Federal Reserve would cool the still buoyant commodities market.
The rise in US import prices is intuitive: Chinese producers cannot play the role of guardians of global inflation indefinitely in an environment of rising input costs. While some observers, including Qu, argue that the price absorption effect remains intact, higher realized import prices support the thesis that rising input costs have eroded the price dampening effect. ‘inflation.
Asymmetric risks related to central banks’ inflation “blind spot”
If the Fed and other major central banks stick to existing frameworks and fail to differentiate between structural and cyclical catalysts for inflation, China’s less effective “inflation suppression” capabilities could lead to changes. market fundamentals.
As part of a successful price control campaign by Chinese regulators and renewed weakness in global commodities due to a strong dollar and a hawkish Fed, Chinese producers could start exporting disinflation again and contribute to a convergence towards what the Fed projects as a “transitional” inflation outlook. However, this is not innovative in terms of asset valuation.
Conversely, the failure of Chinese authorities to control prices and the continued strength of raw materials could exacerbate pressures on Chinese producers and lead to a greater pass-through of inflation to advanced economies. Few investors have experience managing risk in a high inflation environment, and a deviation from the Fed’s dovish policy, or political sponsorship of asset prices, can be bearish towards risky assets and government bonds (risk parity bear complexes and leveraged strategies).
The Fed could change course and treat the inflationary pressure transmitted from China as “structural” in nature and determine that it does not warrant a change in policy. But it would likely spark public scrutiny and amplify political risks, especially as former Fed officials hold key government posts and run influential research institutions. Thus, some may interpret past policy revisions as an acknowledgment of “policy mistakes”.
Market participants face asymmetric risks: positioning themselves for a return to the low inflation status quo and relying on China to remain an “inflation black hole” to justify prolonged accommodative policy, or anticipating a change in inflation regime that increases uncertainty in major asset markets. The likelihood of these outcomes is roughly equal, but the business as usual scenario may result in moderate asset price appreciation, while more persistent inflationary pressure could result in significant bearish revaluation of “policy-backed assets”.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / davidfillion
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