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On a long enough timeline is all inflation transitory?

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On Wednesday the world learned that the US consumer price index had risen to 6.2 per cent in October — its fastest annual pace since 1990.

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

You’d think the news would constitute a fairly disabling blow for “Team Transitory” — those who believe inflation effects are short-term consequences of pandemic-related supply shocks — in their ever intensifying battle against the inflationistas on Twitter.

But no. Team Transitory haven’t given up the ghost yet.

What’s more, on Thursday, they had the Bank for International Settlements, by way of their latest bulletin, coming in with some strategic air cover to revive their case.

It’s called the “bull-whip” effect.

As authors Daniel Rees and Phurichai Rungcharoenkitkul explain, bottlenecks in the supply of commodities, intermediate goods and freight have led to volatile prices and elongated delivery days. But then, in trying to mitigate these problems, supply chain participants inadvertently began building buffers (in already lean networks) exacerbating the problems further.

From the bulletin (our emphasis):

Anticipation of product shortages and precautionary hoarding at different stages of supply chain have aggravated initial shortages (the “bullwhip effect”), leading to further incentives to build buffers. These behavioural changes have the potential to lead to feedback effects that exacerbate bottlenecks. In this respect, there are parallels between supply chain disruptions and the liquidity stresses in financial markets.

A third important background element is the lean structure of supply chains, which have prioritised efficiency over resilience in recent decades. These intricate networks of production and logistics were a virtue in normal times, but have become a shock propagator during the pandemic. Once dislocations emerged, the complexity of supply chains made them hard to repair, leading to persistent mismatches between demand and supply.

What the BIS seems to be saying is that the transitory inflation problem is not dissimilar to a temporary liquidity shortage in a financial market, which — in the absence of a level-headed countercyclical entity like a lender of last resort — always stands to snowball into a full-on financial meltdown through feedback loop effects.

It’s an argument FT Alphaville also made very early on during the pandemic.

To the average hard money fetishist that might sound like an acknowledgment from the BIS that the economy is at risk from falling into a self-reinforcing feedback loop that spirals into hyperinflationary overdrive.

But no, what the BIS is saying is this:

. . . persistent bottlenecks could also prompt corrective behavioural changes over time, eg by providing incentives for investment to expand capacity. Once bottlenecks begin to ease, the feedback loops could operate as a virtuous circle to mitigate the bullwhip effects. In this way, just as bottlenecks have persisted longer than initially expected, their resolution could also follow more swiftly than currently feared.

So it’s all just a necessary market rebalancing. If we survive the storm, we will eventually arrive at an idyllically rebalanced point, characterised by plentiful goods and supply harmony. The market mechanism will deliver us. There is no better cure for high prices than high prices.

Hence they say:

. . . once relative prices have adjusted sufficiently to align supply and demand, these effects should ease. Some price trends could even go into reverse as bottlenecks and precautionary hoarding behaviour wane. The mechanical effect on CPI could well turn disinflationary during this second phase.

Though they do caveat that this is dependent on the situation not triggering an upward shift in wage growth or inflation expectations.

The chances of a wage-price spiral are higher if inflationary expectations become unmoored. Marketand survey-based inflation expectation measures have increased 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 increase in long-term inflation expectations, although the pass-through from short-run inflation expectations to its long-run counterpart has increased (see Boissay et al (2021)). 

The BIS does not comment on the degree to which vaccine mandates might exacerbate labour shortages. Nor does it address the obvious point that monetary authorities have little incentive to discuss their inflationary fears, since addressing the elephant in the room will probably only make things worse.

In case any of this is not clear, the BIS’s Hyun Song Shin — who noted in July markets were pricing in a transitory 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 comparing and contrasting the relative timelines Team Transitory and Team Inflation are using as their comparative bases. Otherwise, on a long enough timeline, hasn’t every inflationary period in history been transitory?

Go figure.

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