According to the Chair of the Federal Reserve Bank (Fed), there is no worry over inflation. Indeed, the Fed is quite prepared to see prices rise across the economy above their 2 percent target rate for a period of time because inflation has been so low for so long. Federal Reserve Chairman Jerome Powell, has even indicated that any significant bounce in inflation over the coming months is likely to be regarded as a one-off. But what if the reason for the low inflation we have experienced over the last three decades is exceptional and these circumstances have also changed?
Economic theory established over two hundred years ago tells us there is a relationship between the demand for goods and the supply. If there is too much supply compared to demand, then the price has to go down to clear excess inventory. Similarly, if there is not enough supply to satisfy demand then prices will rise until demand is reduced (the price is just too high).
The western world has had two very positive shocks to the supply of goods over the last 30 years. First, the fall of communism in Eastern Europe and Russia opened up production facilities as well as growth opportunities previously closed to the West. Suddenly, Volkswagens were not only manufactured in West Germany but in East Germany and in the Czech Republic. Wind the clock forward to the end of the 1990s and, following the hand-over of Hong Kong by the British to the Chinese, massive inward investment saw the Chinese economy open up to the West and turn into the production center of the world.
Both these events saw a significant increase in the supply of a vast range of goods. Interestingly, as Chinese workers became more affluent and did begin to spend more, they also increased their savings and so their consumption of goods per capita compared to the U.S. and Europe remained much lower. However, changes are taking place. Chinese consumers are consuming more and appear to be consuming more goods produced in China. In effect, Chinese consumers are starting to reduce the available supply of goods to the West.
How do I know this? Well, I can see this from the trade statistics published by China and its key trading partners. Across the globe, China appears to export more than it imports, as a quick look at Australia shows. Australia imports much more by value from China than it exports.
In part, this could be because China imports raw materials to add value and export them as manufactured goods. Indeed, this is their stated intent, as we are currently seeing in the case of rare earths. These are vital minerals used across technology from electric vehicles and solar power to the military and mobile phones.
Interestingly, if we look at Australia’s trading relationship with the U.S., we see the reverse, although the numbers are smaller.
In other words, China is not the engine of global growth it was for most of the last two decades. In comparison, the U.S. through its propensity to satisfy local demand by importing rather than producing, has become an engine for global growth. This is a reversal of its role for much of the last century.
But what has this to do with inflation expectations?
The change in the role of China and its manufacturing industry should concern us. From being an engine of increasing supply of a vast selection of goods for more than 20 years, the dramatic increase in domestic consumption looks likely to turn China into a net constraint on global supply.
The world’s largest consumer economy is, of course, the U.S.A. Over the last year, consumers have increased their savings substantially. Some reports suggest an additional $2 trillion have been saved since the start of April 2020. Meanwhile, consumers have also paid down their borrowings – particularly credit card debt. Limited ability to spend over the last year has, of course, been a major factor. However, once we control the COVID pandemic and the economy re-opens, then, as we saw in the housing and auto industries as 2020 progressed, we can expect a sharp rebound in consumer spending. Indeed, the latest retail sales numbers for January showed a staggering 7 ½ percent increase over pre-COVID January last year. So, the outlook is for a further sharp rise in consumer demand – the main driver of the U.S. economy. This increase in demand will likely come up against a shortage of supply globally. In the auto industry, we are already seeing signs of this with the supply of essential materials unable to keep up with demand. As a result, production plants have been closed and the prices of these vital materials have increased dramatically. This includes steel.
Interestingly, if we look at a variety of raw materials, inflation rates since the start of April 2020 far exceed the 2 percent rate of inflation the Federal Reserve has stated as its long-term target.
So, the question that comes to my mind is exactly how high an inflation rate is the Federal Reserve Bank prepared to tolerate before raising interest rates in order to prevent the economy from overheating. One can, of course, be quite cynical. After all, the U.S. government is heavily indebted and would probably be only too glad to see its tax receipts grow with a little help from inflation. However, as those of us who can remember back to the high inflation days of the 1970s, the people who suffer most are individuals on fixed incomes, especially the retired, who depend on reliable income from their investments. In the main, these investors tend to be pensioners and the elderly who do not have the luxury of time to make up for the ravages of inflation on their purchasing power.
Trevor’s articles and contributions to The Berkshire Edge should not be construed as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation. As an author with specific expertise, his contributions reflect his personal views and do not represent Renaissance Investment Group LLC.
