“Break The Chain”: Why A “Painful Recession” Is Required To Crush Inflation Expectations

April 21, 2023   |   Tags:
"Break The Chain": Why A "Painful Recession" Is Required To Crush Inflation Expectations

By Michael Every of Rabobank

The persistence of inflation continues to confound economists and policy makers, as the significant supply shocks that sparked this wave have now largely faded. Therefore, it was not surprising that the accounts of the last ECB meeting, released yesterday, revealed an increasing divergence of views on the inflation outlook. While there is general agreement on the root cause of inflation, it is still hotly debated why inflation proves so persistent. Indeed, in the ECB accounts, we suddenly find that “an important question for the forecasting of inflation was whether firms would continue with the same pricing strategy or would accept lower profit margins in the period ahead.Watch this space as the earnings season really gets going.

In our view, March's mini banking crisis was not severe enough to derail the global tightening cycle. The effort to restore inflation-fighting credibility will therefore persist, with central banks continuing to press forward in spite of those who argue that reducing consumer demand during a supply shock is inefficient. However, these blunt and general measures have yet to bear fruit, and it remains uncertain when they will: despite rapid evolution in mainstream thinking on inflation (… as this is suddenly being required again), economists have yet to produce a model that accurately measures the cumulative impact of the sequence of rate increases seen thus far, let alone one that fully captures the intricate internal dynamics of inflation.

The terms of trade shock that occurred in 2021 and 2022 has made many European and other countries that rely on commodity imports poorer, leading to squeezed real incomes for workers and firms. However, the question of how to allocate these losses lies at the heart of a conflict. According to the traditional story, if both sides try to unilaterally offset their losses, it could trigger successive wage and price increases, risking inflation to become entrenched at a higher rate. The fact that input prices are slowing or reversing, while wage growth is rising and “inflation momentum is remaining high” for all components excluding energy, indicates there is a risk of an increasingly broad-based entrenchment. For instance, the UK this week showed rising wages and stubbornly high services inflation, which only solidifies our long-held call for a 25bp hike to 4.50% at the Bank of England's May meeting, despite plenty of other calls for an early pause.

Rather than the knee-jerk reaction of blaming low unemployment and "too tight" labor markets for the persistence of inflation, falsely implying that workers are the dominant force in this distributional conflict, it is worth noting that an increasing number of politicians and central bankers are becoming more receptive to the notion that a "rise in profits is playing an important role" in driving inflation.

This coincides with a growing popular interest in the terms “excuseflation” and “greedflation”, which suggest that companies are using external cost shocks as an excuse to price-gouge customers and bring in fatter profit margins. After all, consumers are constantly bombarded with news of rising costs for transportation, energy, and agricultural commodities, as well as increasing labour costs, and they have become resigned to the idea that sudden price increases of 5, 10 or 20 percent are reasonable. However, in many cases, the actual cost of producing the product or services may not have been affected as much by these shocks, and some key input prices are now even falling. Yesterday’s reports of a -2.6% month-over-month drop in German producer prices or of the slowest rate of South Korean PPI inflation in more than two years are telling examples, but have received much less attention in the press.

When consumers start to believe that further propagation of last years’ price shocks is no longer fair, which is bound to happen absent any new and obvious inflationary shocks, they may begin to rebel against corporate pricing power. This could trigger increased political involvement aimed at curbing such power one way or another, especially in a scenario in which the labor market weakens and consumer frustration mounts. On that note, yesterday's data showed a 22% year-over-year increase in US continuing jobless claims due to rising layoffs and slower hiring.

Most consumers are already either adjusting their consumption volumes or opting for lower-priced private label goods or cheaper services to make up for the loss in real income. This morning, UK retail sales posted another -0.9% month-over-month fall, with sales volumes now down 1.6% relative to their average level of 2019. Despite this trend, companies that prioritise “price over volume” are still being handsomely rewarded by shareholders. However, companies that try to pursue a “volume over price” strategy, like Tesla, are being punished by investors, even though increasing market share now is as an investment in future market/pricing power.

When conflict arises, such power can come in handy. In the April 12 Global Daily, we highlighted this paper by Lorenzoni and Werning, which offers another conflict-perspective on inflation. They decompose wage and price inflation into an "adjustment" and a "conflict" component. The adjustment component only produces transitory effects and cannot generate sustained inflation. In contrast, the conflict component can generate persistent inflation in both prices and wages. This is especially true when prices and wages are set at fairly long, staggered intervals and firms raise prices not just to stay ahead of competitors, but also to catch up with increases in others' prices since their own last price raise. The same applies for workers, who don’t want to see their own wages falling behind relative to those of others. While this eventually leads to a stalemate in relative prices and wages, with no one benefiting, the changes in prices driven by this conflict result in sustained inflation in all prices. Please note that this can easily occur without having an “overheated economy” or “too much money chasing too few goods”, as long as there is an initial shock in a systemically significant industry that sets off such a dangerous chain of events.

This chain only breaks when the various players in the economy are forced to accept the outcome. This task has been left to the central bank, which entails slowing down the economy to compel some firms to accept lower prices given wages and other prices, and workers to accept lower wages given prices and other wages. As the horse has already bolted, there is still more work to do. A painful recession is probably required to ensure that the actual price increases fall short of expectations and that inflationary momentum gets wrung out of the system. This remains a highly inefficient way to deal with what is in essence a distributional conflict, but do you think there is enough trust or cooperation in today’s economy to find any other solution?

Tyler Durden Fri, 04/21/2023 - 10:05