Why inflation has peaked – Simplify Partners

We are moving towards overcoming the of the supply chain bottlenecks, one of the drivers of price growth
Indicators point to easing of pressures, normalization of the supply side and replenishment of inventories
Deflationary trends also appeared in the first part of the year, starting with a slowdown in global growth, expected to be 50% lower than in 2021
In the meantime, despite forecasts to the contrary, globalization continues to exercise the function of keeping price growth at bay
The uncertainty created by political decisions aimed to form a new geopolitical order is high (as demonstrated by the sanctions on Russia) even if, in a longer term perspective, the deflationary forces appear more robust

Several signs indicate that inflation, one of the most debated topics among economic operators and investors, has reached a peak. What makes us lean towards this thesis is the consideration that the conditions are being created to overcome the collapse of the supply chains, one of the propellants of price growth. The collapse was the result of several causes, which manifested themselves at different times: the imbalance between supply and demand for goods following the pandemic and the subsequent, impetuous recovery of the economic cycle; the war in Ukraine; the restrictions imposed by the Chinese authorities to end the pandemic. And going a little further back in time: the impact on logistics of ESG policies and trade policy followed by the Trump administration since 2016.

What the main indicators say

The interruption in the regularity of supplies, especially from China to the West, has been a decisive driver of global inflation. To understand what has happened it may be useful to compare the evolution of the Global Supply Chain Pressures Index (GSCPI *), introduced by the Federal Reserve to measure interruptions in the supply chains of OECD countries, with the index Global Consumer Price (CPI). The GSCPI typically leads the global CPI movement by nine months.

We thus see that the pressures on the global supply chain, which have remained high since mid-2021, albeit with alternating phases, have registered signs of easing since April. This would support our thesis that global CPI growth is likely to peak in the second half of the year.

The gradual normalization of the situation in China is decisive for making a forecast. In April, due to new lockdowns, the GSCPIpeaked in China, but fell again in May as soon as the health emergency was over. The index, however, still remains significantly above pre-Covid levels.

Our thesis is supported by other indicators. Standard & Poors Global PMI Suppliers Delivery Times Index, which reflects the average delivery times of suppliers, continues to improve and inventory levels are also growing. Positive signals are also coming from the main global shipping indices, for example the Baltic Dry Index and the Drewy World Container Index, which reversed the trend after the heights of late 2021 or early 2022.

The deflationary forces of 2022

In the first part of 2022, trends then emerged which, together, slow down the price race. First, global growth has slowed and is directed towards levels 50% below those of 2021. Declining monetary and fiscal support, the impact of inflation itself on consumer demand and a decrease in unsatisfied demand for goods are together structurally weakening price growth. Hence, less pressure on supply chains and, therefore, on inflation.

Furthermore, the nature of the demand is changing. With the easing of the restrictions imposed by Covid, demand is shifting back to domestic services and therefore imports of goods weigh less. In the United States, the demand for personal consumption services hit a bottom in the spring of 2021 and a similar trend is recorded in Europe.

It is true that the risk deriving from the pressure that logistics workers are exerting to obtain wage increases (in some cases lower than pre-Covid levels) should be considered and it is an inflationary force. Port workers in Germany and rail workers in Great Britain have announced strikes, while in South Korea the truck drivers have already crossed their arms. In the United States, port workers’ unions on the west coast are engaged in tough negotiations even if, according to the declarations of the parties, an agreement appears possible. The risk is there, but it does not seem such as to reverse the trend.

Globalization is not dead, quite the contrary

The globalization of the economy, which makes it possible to take advantage of the differences in labor costs between countries, has been one of the most important deflationary factors of the last thirty years. The evolution of the geopolitical framework and the orientation of political powers in the main economies made it possible to predict an end to the long phase of free movement of goods, people and capital. The facts seem to say otherwise. The rise in customs tariffs of the Trump era simply directed trade flows from China to other parts of the world while manufacturing activities did not return to the United States or Europe. During the pandemic and before the Chinese authorities’ Covid-zero policy took shape, exports from China actually increased.

In short, it will be a long time before we see a change in these supply flows. Even though the cost of labor in China is no longer as cheap as when the country joined the WTO in 2001, a more qualified staff and the inelasticity of certain production processes led to the permanence in China of a large amount of productive activities.

Possible risks of political origin

It cannot be excluded that this overall deflationary picture is troubled by decisions originating from the search for a new geopolitical balance, as we have seen with the recent sanctions imposed on Russia which have certainly added pressure to the logistics chain and therefore to inflation. In the absence of exogenous shocks, companies are still oriented to pursue the lowering production costs, which implies leaving the production structure unchanged and/or turning to countries with the lowest labor costs. The repatriation of production could take place for goods of strategic importance (military supplies, cybersecurity electronic components) but would not change the substance of International flows. In the longer term, we expect global supply chains to further diversify hence further reducing inflation pressures. South, Southeast Asian and Latin American countries, which have a young workforce strongly linked to the West, could be the biggest beneficiaries.

Links: https://www.newyorkfed.org/research/policy/gscpi#/interactive