Why Inflation is Here to Stay

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There are many people who believe that inflation is on its way down and will soon return to 2%. While many people have pointed to the adjustments to the various short-term pressures that have caused inflation to spike since last year such as the war in Ukraine, the supply chain disruptions in China, and the tight labour markets in the US, I believe inflation is here to stay for the long-term, and it would be difficult to get back to the 2% environment.

Geopolitical Tensions

The shift in businesses’ focus from efficiency to resiliency post covid is inflationary in the long run.  While the theory of competitive advantage dominated in the 2000s and 2010s, national security and supply chain resiliency are top of mind these days. Supply chain disruptions caused by covid lockdowns have exposed the risks of just-in-time supply chain management. Rising US-China tensions have convinced more businesses to restore their production facilities despite the associated higher costs. The technological arms race between China and the West has also led governments to be more eager than ever to leverage fiscal policy to foster the industries they see are important strategically—a stark contrast to the laissez-faire approach over the last two decades. The CHIPS (Creating Helpful Incentives to Produce Semiconductors) Act is a prime example of long-run inflationary pressure caused by the US using fiscal policy to bring semiconductor production to the US despite the US not having a competitive advantage in producing them.

Morris Chang, founder, and president of Taiwan Semiconductor Manufacturing Corporation (TSMC), has expressed concern about setting up TSMC's Oregon-based facility:

“We still have about a thousand workers in that factory, and that factory, they cost us about 50 percent more than Taiwan costs.”

“Right now you're talking about spending only tens of billions of dollars of money of subsidy. Well, it's not going to be enough. I think it will be a very expensive exercise in futility.”

Green Energy Transition

The green energy transition and other ESG concerns are another inflationary pressure that is here to stay. And the faster renewables are adopted, the worse this problem is expected to become in the medium term. However, the slower renewables are adopted, the greater impact climate change is going to have on economies in the long term, creating further problems that are beyond inflationary. 

An example of this is the price of minerals such as nickel, lithium, and copper, which are used in the production of green technologies. This new “commodities supercycle” in green energy input minerals is an upside risk to inflation because supply capacity lags demand. And estimates suggest that meeting the Paris Agreement would result in a quadrupling of mineral requirements for clean energy technologies by 2040.

One recent paper estimates that a 75th percentile flood has an instant +0.38 percentage point effect on headline inflation, while 75th percentile droughts increase headline inflation by +1.36pp.  

Implications

Due to these long-term inflationary pressures, I question the ability of the Fed to ease inflation over the long term. As I have mentioned in my previous post, the yield curve currently prices in easing early next year. I am not convinced that inflation can fall to 2% so easily.

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