Some readings on the inflation debate

Is the current inflation transitory or is it the latest episode of inflationary breakout? There debate is almost evenly balanced. 

The former argue that the current inflation is due to the stimulus and shocks imposed by the pandemic, whose effects will wear off soon. The other side invokes Econ 101 to claim that the massive fiscal deficits and eruption in money supply is manifesting as the expected inflationary episode. Besides, they argue that the post-pandemic stimuluses and labour market shifts have left people with significant disposable incomes and encouraged people to leave the labour market. They also argue that the supply chain disruptions will take at least a couple of years to heal, leaving the market with an extended supply shock. 

I am sitting on the fence in this argument. So summarising two papers that came to notice recently (HT: Ananth).

James Montier and Philip Pilkington of GMO argues that monetarist theories of inflation have limited empirical basis and feels that in the absence of a shift in labour's bargaining power, inflation talk is meaningless, 

History teaches us that inflation is... invariably, as Wicksell put it, a “cumulative process” in that it involves a feedback loop between prices and costs. Labour costs are particularly important in the production process, and thus a sustained inflation requires wages to rise significantly faster than productivity (as we have noted before, we have actually been witnessing the opposite situation for a long period of time now – a phenomenon known as wage repression). Without a radical shift in labour’s bargaining power (of which there is yet no sign) it is unlikely that inflation will be able to embed itself in the system. Thus, we believe the upsurge in inflationary angst is likely much ado about nothing.

They plotted average fiscal deficits and average inflation data from 37 countries over the 2009-19 period and found no correlation. 

On the contrary, they found, 

Here we see that not only is the sign wrong – if anything, a higher fiscal balance is associated with higher inflation – and that there is no solid correlation, but that most countries experience between 0% and 2% inflation even though fiscal balances tend to be anywhere between -8% and +2% of GDP. The two extreme outliers also seem to discredit any simple relationship.

Similarly, they show fiscal deficits and inflation in US and Japan over the last 70 and 40 years respectively and finds no correlation. They also point to the poor empirical basis for theories like Philipps Curve and non-accelerating inflation rate of unemployment (NAIRU). 

They point to a sharp rise in US household savings rate due to the pandemic,

They constructed an index of worker bargaining power, the Worker Bargaining Index (WBI), consisting of  number of strike days per year, share of union membership in total workforce, and unemployment rate. Again, far from increasing, they find the WBI declining in recent times.

They argue that any simultaneous supply and demand collapse, followed by a major stimulus will result in a higher price level, which however is unlikely to be a long-lived one. 

In sharp contrast to GMO, analysts at Bridgewater argue that far from a squeeze, "supply of almost everything is at all-time highs". They claim that the monetary and fiscal stimuluses in the aftermath of the pandemic has triggered a demand shock, whose drivers they feel are not transitory. 

The mechanics of combined monetary and fiscal stimulus are inherently inflationary: MP3 creates demand without creating any supply. The MP3 response we saw in response to the pandemic more than made up for the incomes lost to widespread shutdowns without making up for the supply that those incomes had been producing. This is very different than post-financial-crisis MP2, where QE, by and large, was not paired with significant fiscal stimulus but instead offset a credit contraction and, as a result, was not inflationary.

We’re now seeing the inflationary mechanics of MP3 play out and observing just how potent a tool it is. And while the composition of the demand it fueled will evolve (e.g., shift from goods back toward services as COVID recedes), demand is likely to remain highly elevated. There are still large stockpiles of latent spending due to the transformative effects that MP3 has had on balance sheets and the ongoing incentive provided by extremely low real yields, and more fiscal stimulus is on the way. Choking off demand would require central banks globally to move toward restrictive policies quickly, which looks unlikely... the demand-driven nature of the problem results in a game of whack-a-mole: alleviating a shortage in one area will likely just exacerbate the problem elsewhere in the supply chain.

They point out that while US goods production is well above pre-covid trend, demand has exploded.

Incidentally, though supply is much higher than in recent years for copper, aluminium, and nickel, prices are still rising and inventories are being driven down. Similarly, the surging coal prices conceal the reality that Chinese coal production is 20% higher and exports a full 40% higher than at the start of 2020.  They argue that commodity prices will rise because of significant underinvestment in capacity addition over the past decade, and adding new capacity will take time. 

Business inventories are at historic lows as they're drawing down stocks. Shipping costs and delivery times have soared. The extended monetary accommodation and rising wages have meant that housing inventories too have fallen to levels unseen in recent times, leading to rise in housing and rental prices. 

Finally, they point to the labour market trend of people, especially those above 65, leaving the labour market for good, creating a tightness in the market which is unprecedented.