This article first appeared in Forum, The Edge Malaysia Weekly on August 22, 2022 - August 28, 2022
Inflation is rising. The real question for investors is, for how long? Will central banks have the tools to bring down inflation? Or will that trigger a global recession?
The most perceptive writer on this subject is Zoltan Pozsar of Credit Suisse, who has written a remarkable piece called “War and Interest Rates”. He has pulled together lessons from war and linked inflation to geopolitical factors, which central bankers tend to ignore. Central bankers have been too complacent for too long on inflation.
From 2008 to 2021, reserve currency central banks had an inflation target of 2% per annum, but could not reach that point, irrespective of how much monetary creation they tried through quantitative easing and other tools. In an influential 2020 book, The Great Demographic Reversal, London School of Economics professor Charles Goodhart and Manoj Pradhan point out that since the early 1980s, inflation was low around the world because of a demographic sweet spot from the labour shock that China and later other emerging markets brought to global production, resulting in excess supply of goods and services whereby there was no inflation. That sweet spot has turned sour because China is ageing, globalisation is slowing and low interest rates did not induce investments in long-term infrastructure, so that supply constraints are building up. Post-pandemic, demand has shot up, but supply cannot match it, so inflation is inevitable.
In 2021, former Bank of England governor Lord Mervyn King warned that central bankers were applying what he called King Canute theories of inflation, using models that assumed that inflation would always return to a low level, just like the legendary King Canute asking the tide to turn. He called quantitative easing a dangerous addiction and warned that central banks should have raised interest rates earlier in 2021, when the numbers first began to spike.
In my review of Goodhart’s book, I wholeheartedly agreed that central bankers were too complacent over inflation, because their models assumed that supply of essential food and energy would respond as before, so consumer prices would remain low despite larger and larger increases in liquidity. Central banks have been financing larger and larger fiscal deficits without realising that the monetising of the largest debt would sooner or later cause inflation to break out.
Modern monetary theorists are the most extreme versions of this line of thinking. They think that since inflation is no more of a threat, governments can spend more and face no hard budget constraints. But there is no such thing as a free lunch.
The Russia-Ukraine war shattered such delusions. As Pozsar correctly reminds us, war is inflationary because it disrupts supplies. Russia and Ukraine together account for roughly 10% of the world’s supply of food, energy, fertilisers and key minerals. Furthermore, the pandemic fostered the conditions for the Great Resignation, as workers who had got used to working at home and being paid generously by government subsidies resigned so they could go back to work under better conditions. Thus, the combination of labour withdrawal, supply chain disruptions due to sanctions and bottlenecks in semiconductors added to the inflationary pressure.
As Pozsar puts it: “Think of the economic war as a fight between the consumer-driven West, where the level of demand has been maximised, and the production-driven East, where the level of supply has been maximised to serve the needs of the West.” If war tensions rise, the Rest may be willing to supply only at higher prices or even begin to shut off supplies, such as the Russian cut in gas supplies to Europe.
But is inflation cyclical or structural? All the mainstream economic forecasts seem to suggest that inflation will peak this year (Europe’s gas winter) and then taper back thereafter. But since almost all war pundits think the Ukraine war will drag on and the labour shortage is structural, even while the supply chain bifurcates into one for the West and another for the Rest, then inflation will go on higher for longer. This would mean that social inequality would worsen. Inflation can only be squeezed out by either a deep recession or a US Federal Reserve chair Paul Volcker-type shock of very high interest rates as in the 1980s.
In short, Pozsar worries that the current model of inflation, where central banks have not priced in geopolitical risk premia, may be wrong because “in fact we live in an unstable world where geopolitical risk premia are rising and where supply-side issues are more powerful than demand management”.
He attributes the previous low inflation to three pillars: “First, cheap immigrant labour keeping service sector wages stagnant in the US; second, cheap goods from China raising living standards amid stagnant wages; third, cheap Russian gas powering German industry and the EU more broadly ... All this has worked for decades, until nativism, protectionism, and geopolitics destabilised the low-inflation world”.
Pozsar sees that two polarised world blocs with separate but interlocking supply chains will usher in an era of higher cost-push inflation. Any realignment of supply chains imposes huge costs, which must be passed to the consumer. Thus, central bank monetary policy faces two contradictory dilemmas of local politics and bad geopolitics.
If central banks are too slow in raising nominal interest rates when inflation is high, the negative real interest rates would impose an inflation tax on the poorer population, causing even more social unrest and populist policies that drive more polarisation. Under this scenario, look out for more loose monetary and fiscal policies that do not augur well for the long-term future.
However, since there may be two blocs (West and Rest) with different monetary and fiscal policies, the Rest may end up with stronger relative structural competitiveness if they are taking an earlier dose of tough medicine. The West may opt for higher military expenditure for an arms race that could be short-term reflationary. This was what happened in World War II. The Great Powers escaped the Great Depression by arming for war, ending up with massive destruction for all.
The 19th century geopolitical strategist Harold Mackinder had a maxim: “Whoever controls Eurasia controls the world.”
British and American grand strategy in the 19th century was designed to prevent anyone controlling Eurasia. But that is exactly what Nato has achieved by driving Russia and China closer together. Both countries in alliance would command a vast part of Eurasia, with Russia’s massive natural resources complementing the needs of China for more food and energy for her larger population.
The Nato bloc, on the other hand, relies on the Rest of the World to provide key resources, because they run trade deficits, but were able to offset these deficits by running up higher debts. But with the weaponisation of finance, the Rest may be less willing to finance the West if they get sanctions for reasons beyond their control.
Thus, central bankers can no longer operate independently of both domestic monetary policy stances, which have huge geopolitical implications that feed back into domestic public sentiment. Mickey Mouse finance does not carry a wizard’s wand that ensures that supply is infinite to keep inflation low. Globalisation increased that supply, but deglobalisation would be inflationary, so either central banks act to hold down inflation or lose both their independence and policy credibility.
Central bankers have been wizards at creating virtual wealth through manipulating their balance sheets to induce (hopefully) long-term supply. When that excess liquidity is spent mostly on speculation on asset bubbles and consumption, inflation would come sooner or later. The Covid-19 pandemic and Ukraine war were the triggers for that inflation.
Quantitative easing through bloated central bank balance sheets created artificial central bank profits, which helped reduce fiscal deficits. When the cycle reverses, central banks will incur losses because they would pay higher interest rates. So, we are in that vicious circle phase whereby central bankers will be blamed for all the ills of the present due to the bad policies of the past.
War has traditionally been fought with monetary and debt creation. Britain was able to beat her continental rivals in the 19th Century because her financial markets remained open and she could increase her national debt and finance it at cheaper rates than the European land-based powers. The US financed World War II through increasing its federal debt to a peak of 106% of gross domestic product by 1946. Fiscal hawks should well reflect that the US may well be embarking on the road to World War III with peak World War II debt, since current US government debt is already at that level.
To sum up, the weaponisation of everything means that Great Power rivalry will depend on which side adopts the right package of policies that will ultimately determine supremacy. Monetary, fiscal, structural and defence policies are all entangled. Investors would do well to bear that in mind in their asset allocation policies.
Tan Sri Andrew Sheng writes on global issues that affect investors
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