Despite inflation appearing to cool in many economies, inflation is still very much a problem and one that Central Banks are finding themselves on the other end of the tug-o-war rope trying to control. Despite many advanced economies increasing interest rates at record rates, inflation didn't seem to budge. It's almost as if interest rate increases had zero impact on inflation, and you would be mostly right.
When people think of inflation, they think of one type of inflation. There are multiple types of inflation, but three primary types.
- Demand-pull inflation
- Cost-push inflation
- Built-in inflation
Many mistakenly believe that inflation can only be caused by printing excessive money and devaluing your currency. And yes, that is one-way inflation can be created. Increasing the money supply means more demand for goods and services, aka demand-pull inflation. While much money was printed from 2020-2022 due to the pandemic, it didn't contribute to the inflation we see as much as people think.
The primary cause of inflation in most countries (the UK, USA, Australia and New Zealand especially) is cost-push inflation, initially driven by demand-pull inflation.
Let's talk about demand-pull inflation
Before we delve into cost-push inflation and why it contributed to white-hot inflation, we must differentiate between demand-pull inflation. It is about what you would expect. Demand-pull inflation is when demand for goods and services increases their price. As supply dwindles and demand increases, people will pay more. It's economics 101.
We see demand-pull inflation quite often. Have you noticed at Christmas, the cost of plane tickets increases? During holidays when people are going away and booking hotels, the price increases. Demand-pull inflation. That's not the type of inflation we are experiencing. The population didn't just all of a sudden increase. People didn't start buying more televisions and demanding services all of a sudden.
Supply became constrained due to global factors, not because demand increased. In many instances, demand remained the same or even dropped. Still, supply became an issue due to COVID-19, specifically, China and its COVID-zero strategy that involves closing down entire cities, ports, factories and other cogs of the global supply chain.
As this was all happening, Taiwan was experiencing one of its worse droughts on record. And if you want to know why that is significant, look no further than Taiwan Semiconductor Manufacturing (TSMC). They are one of the world's largest semiconductor makers, accounting for over 50% of the chip market. A lot of water is needed during semiconductor manufacturing, around 156,000 tonnes daily (85% of that is recycled). Still, requiring water during a drought complicates things.
You could argue this is a case of more competition. The capital required to create the fabrication plants and specialised equipment runs into the tens of billions (probably made worse by inflation). It's why companies like TSMC have achieved such widespread market share. They are one of few companies that can produce needed semiconductors at scale. Even still, it takes years to bring these plants online.
Now, you see, we have a perfect storm. Supply chains halted or slowed to a crawl, and container ships were piling onto ports and overloading them—many reached capacity at one point.
Cost-push inflation has entered the chat...
Where cost-push inflation exists, it is usually, in most cases, driven by demand-pull inflation. This all feeds into cost-push inflation. Demand might not have increased or even lowered, but people were still buying new phones and TV. People still wanted new cars or building new homes, renovations and repairs requiring parts and labour. As a result of these delays and production issues, the cost of raw materials went up.
As the price of raw materials increases, overheads increase for businesses, and those businesses increase their prices. Once again, I want you to keep in mind that demand might not have even increased. It could be stable. But the input costs go up, and these costs need to be passed on. It puts businesses in a difficult situation because they have margins and to keep those margins. Many are unlikely to absorb them as costs go up.
And just like drought being a wildcard during the pandemic, another wildcard emerged, strengthening cost-push inflation.
The Russia-Ukraine Invasion
When Russia invaded Ukraine, it felt like the world destabilised quickly. Just as people were optimistic about the future, emerging from the lockdowns and mandates starting to lift, crazy Putin decided he would amass a tonne of troops and military hardware on the border and push into Ukraine.
Like throwing a Molotov cocktail into a fireworks store, the ripples began to make their way through many parts of the world. While Ukraine was experiencing loss of life, destruction, and atrocious war crimes from Russia, other parts of the world were affected in other ways.
Russia is a large exporter of gas and other goods. Ukraine was a large exporter of grain, metals and other things too. This resulted in an energy crisis, with talk of Europe experiencing a bleak winter due to Russia turning off the gas tap. Europe had shamelessly become reliant on Russian gas. As sanctions and embargoes set in, Russian gas and other exports were radioactive.
The energy crisis resulted in many countries reliant on gas to panic. Gas is one of the primary inputs in a lot of manufacturing, from steel to foods like cereals and other things. The cost of gas began to increase sharply, seemingly out of control like a Tesla on autopilot driving down a busy sidewalk without a care in the world. Great for the gas companies making record profits, but not so great from the inflation perspective.
You will see that many countries rely on gas as part of their electricity production. In Australia, we produce most of our electricity from coal, like in other countries. However, when these ageing coal generators go down for maintenance or due to other problems, gas is used as a backup.
In June 2022, Australia was faced with a serious problem. A bunch of coal-powered generators went down and, as a result, required gas generators to be used. This caused a significant spike in the electricity price on the spot market, where the cost of generation went up significantly. Once again, more people didn't just start using more electricity. The population didn't balloon overnight, but issues with power generation, gas generator backups and the price of gas caused a serious problem.
You hear of power problems in third-world dictatorships like North Korea, where blackouts and rationing are the norms, but a first-world advanced country like Australia faces similar conditions? It's embarrassing on so many levels. As a result, the energy regulator AEMO took the unprecedented step of intervening in the market to ensure enough supply.
AEMO suspended the spot market because the price of producing electricity reached levels where generators were losing money (the cost to produce electricity was higher than it was being sold for), so some producers started to turn off generators. When AEMO stepped in, it forced these generators to remain online. I believe they were compensated, but it highlights the problems of these privatised for-profit markets for critical infrastructure.
Where I am heading with all of this is, despite Australia being one of the world's largest LNG exporters, the price started to skyrocket. Because Australia lacked domestic gas reservation or price caps, despite plenty of gas and no shortages, Australian businesses started paying more. In some cases, double. As the price of electricity increased, so did the cost of goods and services. Even the Reserve Bank of Australia admitted the government could do more to control inflation if it did something about rental and energy prices.
RBA governor Philip Lowe during a Senate Estimates Enquiry, said:
One way of tackling inflation induced by supply-side shocks is to address the supply side. And if we can do something on energy and rents next year, inflation will come down quickly.
The Australian Central Bank admitted in language as clear as day that supply-side shocks are one of the main reasons Australia has high inflation. Fortunately, the Federal Government has recently intervened and proposed price caps on coal and gas for 12 months, which might help. Rents are another problem.
One thing worth pointing out that arguably made inflation worse in Australia is the floods certain parts of Australia experienced in 2022. Two major flooding events caused the cost of certain grocery items to increase dramatically. Cheese, milk, fruit and vegetables were all severely impacted due to the weather. They were compounding an already bad problem.
The waiting game
This is a lot to digest, but the main point I want to make here is that despite central banks swinging their inflation squashing hammers by increasing interest rates, the underlying cause of inflation was not being addressed. Unless central banks can increase supply, they can only try and decrease demand, even if demand hasn't significantly increased.
There is merit in reducing demand by decreasing people's available money, even when supply-side problems are the main cause. However, increases can only go so far before the inverse happens and the economy breaks. The warning bells are already ringing about recession, which has become a self-fulfilling prophecy.
And if inflation doesn't continue to resolve itself, we will see the third type of inflation creep in: built-in inflation.
Effectively, built-in inflation occurs when people start demanding higher wages. When wages go up, people have more money, which normalises inflation. Central banks warn against people demanding higher wages, and the RBA in Australia was threatening further sharper increases if people started to demand more money. Perhaps ironically, amongst all of this, real wages are still at 2008 GFC levels in many parts of the world, especially Australia.
As inflation lingers, the need for higher wages increases. Despite central bank's warnings, real wages need to come up regardless, just carefully to avoid a wage-price spiral where inflation is reinforced and unable to come down to target levels.
We are now, fortunately, starting to see inflation lower. Many economists believe we are at the peak, and inflation in the US recently came below estimates. Still too high by Federal Reserve inflation target standards, but a step in the right direction. It's a similar story in Australia and other countries. Inflation has most likely peaked.
Even if central banks waited to increase interest rates, we would still probably see inflation peak and fall like we are now. The reason is simple: supply-side problems are starting to subside, supply is increasing, and prices for raw materials are beginning to trend down. The tell is that the futures markets for gas and oil have fallen significantly.
Posted Using LeoFinance Beta
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