By Dzhan Yusnyu, Analyst

On the tip of all tongues, inflation is a pernicious risk to the domestic economic outlook. Federal Reserve policy has changed to tolerate sporadic inflation overruns greater than the 2% long-term target, however, the blunt tools of hawkish monetary policy could still be used to rein in inflation.

The market’s conviction on the length and severity of price pressures is waning – recent developments in the labor force, supply chains, and energy markets challenge the transitory narrative. Despite this, Horizon believes inflation will be transitory. We see the deflationary pressures of tech-enabled productivity and demand destruction created by market forces far outweighing inflationary pressures stemming from an uptick in real wages, tight supply chains, and booming energy costs.

Productivity Isn’t Everything, But, In the Long Run, It Is Almost Everything

– Paul Krugman, Economist

When analyzing future growth trajectories, there are three essential inputs to consider – labor, capital, and technology. History tells us that technological advancements allow for increased productivity of capital for the labor force that uses it. So, if real wages grow, but the rate of productive technological development grows at an equal or greater rate, aggregate output will grow more rapidly than real wages. Said another way, there will be more things made and services rendered than money in people’s pockets to buy them, leading to downward price pressures in the long run.

A clerical worker automating certain functions using software has the capability to produce more than one who is not. Technology allows the production of more goods and services with less labor. Fields such as computing, artificial intelligence, robotics, among others, have and should continue to generate productivity gains that have the potential to far outpace the rate of wage gains. To put things into perspective, let’s compare our current situation with two other times in history when inflation risks were high, The Great Inflation of the mid-1970s to early 1980s and the Tech Bubble of the mid-1990s to early 2000s. Looking at Figure 1, although productivity growth in the Internet Age of today is not as strong as it was in the Tech Bubble, when computing really took off, it is materially stronger than during The Great Inflation.

Another helpful comparison can be seen in unit labor costs. While workers in the lowest rung of the income ladder are currently experiencing strong wage gains, we do not believe this is a prelude to a wage-price spiral – productivity gains are simply too strong. Figure 2 helps make that point by comparing unit labor costs in the Great InflationTech Bubble and the current Internet Age. We can conclude that the current trajectory of wage gains in the Internet Age are more like those of the Tech Bubble, with similar levels of productivity growth. This is not a combination that would drive persistent inflation, based on historical analysis. Conversely, in The Great Inflation era, unit labor costs grew at a faster rate than domestic labor productivity – something that is not the case in the current macroeconomic backdrop.

This Supply Chain Stuff is Really Tricky

– Elon Musk, Tesla CEO

Supply chain disruptions created by the pandemic have generated inflationary pressures in goods prices that we expect to be transitory. Looking at the current composition of inflation, segments most impacted by the initial reopening have reversed their upward trajectory in recent months (Figure 3).

Many of these initial price pressures have eased as high prices have led to demand destruction and as supply-chain bottlenecks have cleared. However, there is one area we are monitoring closely as it bucks this trend. The extreme demand in semiconductors has not subsided and has the potential to hamper downstream manufacturers as the trend towards digitization and productivity gains continues, a potential risk to our outlook.

Drill, Baby, Drill!

– Michael Steele, Fmr. Lieutenant Governor of Maryland

On energy, commodity feedstocks like natural gas are rising, and in Europe, skyrocketing to unprecedented levels. Historically, energy prices are notoriously cyclical and as a result we are monitoring to see if this is also a temporary shock – although we can’t rule out the possibility of a higher energy cost floor as a result of green-energy policies. For example, the new Five Year Plan in China calls for an approximately 3% per annum increase in natural gas consumption while simultaneously reducing coal consumption in order to generate less pollution.1

We believe that high energy prices will eventually lead to low energy prices: demand destruction and market prices that drive more supply will eventually lead to relief, but this may not happen for a while.

Restarting energy feedstock operations, constructing infrastructure, and finding and training the manpower to build and maintain it takes time. That being said, energy inflation is currently a bigger issue for Europe than for America. Their over-dependence on Russia’s limited supply of natural gas exports2 for heating in the winter makes it especially susceptible to a shock in energy prices, as is now all too clear. Although the composition of inflation has shifted to reflect higher energy prices, the looming energy crisis should not generate anywhere near the same magnitude of price pressures in the U.S. as in Europe due to plentiful supply at both home and from neighboring Canada. The geographical isolation of the United States ring-fences the issue of energy cost, acutely so in natural gas, due to the configuration of the midstream infrastructure that transports energy feedstocks.

Conclusion

We are currently experiencing inflationary price pressures and these will likely continue for some time – they may even worsen in the short term. Structurally, deflationary forces such as productive technological advancement, we believe, will continue to keep a lid on inflationary pressures in the long term. Supply chains and energy costs that are providing inflationary pressures now are likely to lead to deflationary pressures as soon as the undulating reverberations of a full economic pause followed by a manic, stimulus-fueled reopening, die down.

Horizon’s complete suite of 2022 outlook articles are found at focus.horizoninvestments.com


1 https://www.carbonbrief.org/qa-what-does-chinas-14th-five-year-plan-mean-for-climate-change
2 https://www.nature.com/articles/d41586-019-03694-y

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