How difficult will it be to get inflation back to 2% sustainably?

Inflation in Western nations remains stubbornly high, despite a series of interest rate hikes. How long will it take for the world’s inflation problem to be solved?

| 7 min read

Central banks generally have an inflation target of 2% to maintain price stability. If prices go up quickly or move around a lot, it’s hard for businesses to set their prices and for people to plan their spending. For about 40 years they had considerable achievement in keeping inflation low and near target. However, that all changed at the start of last year – and Western economies have suffered from runaway inflation.

Despite steep rises in interest rates, price rises remain significantly above target in Western nations. Central bankers tell us to expect interest rates to remain “higher for longer” to get inflation back to their 2% target.

Price stability supported by significant tailwinds

To answer this question, we first need to look at the factors that ensured inflation remained on or near target in the preceding decades. These targets were supported by some significant global tailwinds. Perhaps the most significant of these is globalisation.

Globalisation is defined as the process of growing interdependence among the world’s economies, in terms of cross-border flows of trade, finance, and information. It kept a lid on inflation in several ways. Globalisation affects consumer prices through cheaper imports, increased labour supply, increased competition, and integration of global supply chains. These save costs for businesses, keeping price rises in check.

The energy price shock that occurred in 2022 is now largely gone, but the energy supply and demand balance remains precarious and limits the potential relief on inflation going forward.

Better geopolitical relations following the fall of the Berlin Wall and the opening-up of Chinese trade routes were significant factors in this trend too. Globalisation and disinflation go hand in hand. Significant efficiencies were also made in trade and logistics. Ever-larger cargo ships have reduced shipping costs and relatively cheap fossil fuels have kept costs low. The development of inventory management systems also reduced cost burdens on businesses. So-called ‘just in time’ management helped to reduce investment in inventories and limit the need for promotional activity to clear warehouses of unsold stock. This all led to a range of highly convenient and disposable cheap goods, regardless of any impact on the environment.

But what about now?

In the months following the Russian invasion of Ukraine, there was great uncertainty around how sanctions would affect global food and energy supplies. Natural gas prices peaked in August 2022 and the price of Brent crude oil a month earlier, with both falling back to 2021 levels. However, the energy price shock that occurred in 2022 is now largely gone, but the energy supply and demand balance remains precarious and limits the potential relief on inflation going forward.

Many of these tailwinds that helped keep inflation low for decades have either played out or in fact are reversing. Many Western companies outsourced their manufacturing and supply chain to China to cut costs, but the one-off benefit of accessing a cheaper labour force has diminished as Chinese wages are now growing faster than in the West.

This means the Asian nation is losing the low-cost advantage that it had enjoyed for years. The gap between wage costs has shrunk to an extent that it is no longer sufficient to extend the production location trends of the past. Covid-19 also highlighted the risks around the trend to de-globalisation.

When borders were closed it became clear that many supply chains were unacceptably complicated and many companies are now onshoring or nearshoring their supply chains because their complexity resulted in significant costs and shortages during the disruption. Temporary trade restrictions and shortages of pharmaceuticals, critical medical supplies, and other products highlighted their weaknesses. This reorganisation of supply chains will prove expensive for companies in the short term, which will be a headwind for central banks trying to get price rises down to target.

Politics boosting deglobalisation

It’s not just supply-chain concerns that are driving the deglobalisation trend. Geopolitical relations are tense at best – and there is little co operation on the horizon, with more barriers being raised. Tension over technology between Washington and Beijing are significant, with trade barriers occurring in semiconductors, telecoms equipment and other cutting-edge areas. These are now considered matters of national security, so this trend is unlikely to be reversed any time soon.

In the US, both Democrats and Republicans are united on this front, with Joe Biden continuing the trade policies of his predecessor Donald Trump. The Biden administration has put in place a set of export controls banning Chinese companies from buying advanced microchips and chip-making equipment without a license. US diplomats then strong armed other countries such as the Netherlands, a major chip equipment producer, to stop such sales too. In July, Beijing responded by imposing export controls on two strategic raw materials – gallium and germanium – that are critical to the global chipmaking industry.

The green agenda and move to ‘net zero’ emissions is also a headwind for
central banks. The green transition and responsible management will continue to focus on removing exploitation, better environmental outcomes and more sustainable business models. This will lead to a better world order, but it can come at a significant cost to companies and add pressure to prices.

Rates will remain high for quite some time

Ultimately, given the headwinds, if central banks want a 2% target on inflation, they will need to keep rates on the restrictive side of neutral for a long period. These headwinds will make it difficult to manage in the medium term and forecasting remains a challenge. In fact, central banks failed to spot these inflationary pressures building in the first place.

The Bank of England has conceded there are “very big lessons to learn” in setting monetary policy after it failed to forecast the rise and persistence of inflation. Governor Andrew Bailey has now told the House of Commons Treasury Select Committee that the central bank’s own forecasting model was not delivering accurate results and the Monetary Policy Committee had reduced its role when setting interest rates.

All these factors mean it is difficult to say exactly how long it will take to get inflation back to target, but clearly the ‘higher-for-longer’ mantra that is coming from central banks is correct. We should prepare to see both inflation and interest rates remain higher than we hoped for quite some time.

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