On a long enough timeline, is all inflation transient?

On Wednesday, the world learned that the US consumer price index had risen to 6.2 percent in October – the fastest annual pace since 1990.

Inflationists like Steve Hanke were indignant that US inflation was not a temporary supply chain problem. “Shifts in consumer spending have resulted in broad-based price increases across spending categories,” because “the incompetent Fed has produced a huge amount of excess money,” he proclaimed.

One would think that the news would be a rather debilitating blow to “Team Transitory” – those who believe inflationary effects are short-term consequences of pandemic-related supply shocks – in their ever-intensifying battle against the inflationists on Twitter.

But no. Team Transitory has not given up the ghost yet.

What’s more, on Thursday they got the Bank for International Settlements, via their latest bulletin, to come in with some strategic air coverage to revive their case.

This is called the “bull-whip” effect.

As authors Daniel Rees and Phurichai Rungcharoenkitkul explain, bottlenecks in the supply of raw materials, intermediate goods and freight have led to volatile prices and extended delivery days. But then, in an attempt to alleviate these problems, supply chain participants inadvertently started building buffers (in already lean networks), which exacerbated the problems further.

From the bulletin (our highlight):

Anticipating product shortages and preventive hoarding at various stages of the supply chain has exacerbated the initial shortage (“bullwhip effect”), leading to additional incentives to build buffers. These behavioral changes have the potential to lead to feedback effects that aggravate bottlenecks. In this respect, there are parallels between supply chain disruptions and the liquidity burden in the financial markets.

A third important background element is the sleek structure of supply chains, which has prioritized efficiency over resilience in recent decades. These intricate networks of production and logistics were a virtue in normal times, but have become a shock propagandist during the pandemic. Once dislocations occurred, the complexity of supply chains made them difficult to repair, leading to persistent imbalances between demand and supply.

What the BIS seems to be saying is that the temporary inflation problem is not unlike a temporary lack of liquidity in a financial market which – in the absence of an equilibrium countercyclical entity such as a lender of last resort – always stands to snowball into a complete financial meltdown through feedback loop effects.

This is an argument that FT Alphaville also put forward very early in the pandemic.

To the average tough money fetishist, it might sound like an acknowledgment from the BIS that the economy is in danger of falling into a self-reinforcing feedback loop spiraling into hyperinflationary exaggeration.

But no, what BIS is saying is this:

. . . persistent bottlenecks can also cause corrective behavioral changes over time, e.g. by providing incentives for investment to expand capacity. When bottlenecks begin to ease, the feedback loops could act as a vicious circle to mitigate the bullwhip effects. In this way, just as bottlenecks have lasted longer than originally expected, their solution may also follow faster than currently feared.

So it’s all just a necessary market balance. If we survive the storm, we will eventually reach an idyllic rebalanced point, marked by abundant goods and supply harmony. The market mechanism will supply us. There is no better cure for high prices than high prices.

That’s why they say:

. . . when relative prices have adjusted sufficiently to accommodate supply and demand, these effects should diminish. Some price trends may even go in the opposite direction as bottlenecks and preventative hoarding behaviors diminish. The mechanical effect on CPI may well become disinflationary in this second phase.

Although they make reservations that this depends on the situation not triggering an upward shift in wage growth or inflation expectations.

The chances of a wage-price spiral are greater if inflation expectations loosen. Market and survey-based inflation expectations have risen in recent months alongside tighter bottlenecks, albeit from very low levels in 2020. It is challenging to identify how much bottlenecks directly contribute to the recent rise in long-term inflation expectations, although the impact of short-term inflation expectations its long-term counterpart has increased (see Boissay et al (2021)).

BIS does not comment on the extent to which vaccine mandates may exacerbate labor shortages. Nor does it address the obvious point that monetary authorities have little incentive to discuss their fears of inflation, as it will probably only make things worse to turn to the elephant in space.

In case any of this is not clear, BIS’s Hyun Song Shin – as noted in the July markets priced in a transient effect – has taken to Twitter to explain it all in the far more digestible medium of Tweets. You can read his thread here.

What we think would be useful at this point is to compare and contrast the relative timelines that Team Transitory and Team Inflation use as their comparative basis. Otherwise, on a long enough timeline, has no inflationary period in history been transient?

Go figure.

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