Weekly asset allocation: supply worries about inflation
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In the 1970s, the United States had a serious inflation problem. By the end of the decade, it had become the most crucial economic policy issue. Although inflation can be a complicated topic, one way to simplify it is to view it through the intersection of aggregate supply and aggregate demand.
On this stylized chart, price levels are rising. In the short term, the most common way to address the price level would be to engage in austerity policies, for example by raising interest rates, raising taxes, cutting spending. However, this result also reduces production, which means that growth decreases.
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In the late 1970s, President Carter began to implement deregulatory policies. The objective was to influence supply. By expanding supply, price levels would fall and production would increase.
The supply-side policies of the Reagan/Thatcher Revolution were primarily deregulation and globalization. Deregulation has allowed the rapid introduction of new techniques and technologies. Globalization has naturally widened the available offer. Both undermined the power of labor to push price increases through the economy.
The recent rise in inflation raises questions about future price developments. The FOMC maintains that inflation will be “transient”. Although the actual definition of the word, at least in the context of politics, is “fuzzy”, it seems that the price increase will moderate at some point.
Our concerns are twofold. First, using the second chart, we would say that the supply situation has moved from S’ to S. Supply chains have been disrupted and supply will remain tight until they are repaired. However, the extent to which inflation is transitory may depend on how these supply chains are fixed. It is important to note that globalization is based on a hegemonic power that provides global security and a reserve currency. America’s hegemonic position has become less certain, as Americans seem less willing to make the sacrifices necessary to retain their role. If so, a return to S’ is less likely.
Another factor is related to deregulation. In the 1970s, underinvestment and misinvestment were evident. The “rust belt” occurred to reduce the bad investment that had emerged. To make new investments, savings had to increase, and the most effective way to increase savings is to reduce taxes on higher income brackets. Although aggregate savings do not necessarily increase, they are concentrated in fewer households, making it easier to concentrate investments in a similar way. However, over time, deregulation has tended to create industry concentration. Concentrated industries can hinder the expansion of supply.
Under competitive conditions, extraordinary profits tend to attract new entrants into the industry. As new entrants enter the market, individual company profits eventually decline. Moreover, the expansion of competition makes it difficult to raise prices. Competition acts as a brake on inflation; if higher costs affect the industry, it may simply lead to lower profit margins. But, with the concentration, the possibility for new competitors to enter the market can be thwarted. Therefore, profits may persist. An oligopoly or monopolist may not expand its capacity at high prices and may simply accept high profitability.
The economic term for this is “market failure,” where the market fails to deliver the best outcome for society. In the 1970s, supply constraints stemmed from the lack of incentive to invest. Taxes were too high and regulations increased costs and also discouraged investment. Our current situation looks different. As the world de-globalizes, prices will rise as supply tightens. Ideally, this increase in price levels will trigger a supply response; however, if the industry is too focused, the response may not occur to the extent required.
It is too early to tell if this is the situation we face, but the longer transitional price levels remain, the more we have to entertain the idea that a period of higher inflation may be upon us. We still don’t see any signs that we’re going back to the 1970s – the labor force is still too weak and inequality favors moderate inflation. But just because we don’t see circumstances resembling the 1970s doesn’t mean we’re going to see inflation levels consistent with
last two decades.
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