Market Update: PPI pullback and the ‘new normal’ for inflation

In that time, global demand and price pressures have eased greatly. Energy prices – particularly for wholesale natural gas – have fallen substantially since November on the back of a much warmer winter than expected. Even Bank of England governor Andrew Bailey – a committed hawk in the global inflation fight – has admitted this makes the job much easier. He is now optimistic about an “easier path” out of inflation pressures.

Capital markets are buying into this optimism, but not everyone is convinced. Christian Ulbrich, chief executive of global real estate firm JLL, told the Financial Times this week from the Davos World Economic Forum that “fundamental trends” mean “inflation will stay persistently around 5%”. This is reportedly a view shared by many of the movers and shakers in Davos, and it backs up commentary we are seeing quite widely in the financial media.

There is an emerging view that the old regime of 2% average inflation is gone, and will be replaced by an average much closer to 4% over the long-term. The thought is that, due to structural changes in the global economy, central banks will no longer feasibly be able to target 2% inflation and will have to adjust their targets higher. This will mean structurally higher interest rates too – a far cry from what we saw in the period between the global financial crisis and the pandemic.

The long-term factor that most strongly drives this view is globalisation, or lack thereof. Since the 1980s, economies have become increasingly interconnected, putting a structural downward pressure on prices by increasing the available supply of goods and thereby indirect access to much cheaper labour. That process no longer looks guaranteed, and is arguably going into reverse. This is partly due to longstanding political grievances which are delivering more protectionist politics, and partly due to concerns over supply chain security. Trump’s trade wars and Brexit are an example of the former, while Europe’s move away from Russian gas is an example of the latter.

US-China trade tensions are a clear example of deglobalisation, but prospects for reconciliation have improved substantially in the last month or so. That brings us to the next corollary, however: China’s integration to the world economy over recent decades has been a structural force holding inflation back. In simple terms, this was due to the cheapness of producing goods in China versus elsewhere.

This is no longer the case. Wages and production costs have increased dramatically in the world’s second-largest economy, to the point where China is no longer a deflationary force. Quite the opposite, in fact, as strong Chinese growth generates demand for commodities. Now, when China goes on a growth binge, it puts upward pressure on global input costs.

This is certainly an upward force on global inflation, but whether this translates to structurally higher inflation in the long-term is another matter. On that front, we can only point out that moving to a regime of 4% annual inflation is not a simple matter. Inflation disproportionately affects lower income earners by destroying their purchasing power. To counteract this, the economy has to give disproportionate wage increases to the less well-off, or else inequality grows dramatically, with potentially disastrous political consequences.

That is fine as an economic model; it is how most western economies operated from the end of the second world war up to the 1970s, a period of great improvement in living standards. But it means that returns to labour outpace returns to capital – which in turn means a structural barrier to equity market growth. Again, none of this is necessarily a bad thing – especially if it creates a more dynamic underlying economy with more growth from growing consumer demand – but investors have to recognise what a 4% annual inflation regime would mean. Davos attendees should be careful what they wish for.