Is inflation coming back? Financial market fears

Article published in Les Echos in 2006

In order to properly answer this question, we first need to set the record straight as regards the difference between inflation and an inflationary regime. How much do prices generally have to rise for this economic headache to begin skewing indicators and derailing economic agents? By 2%? Perhaps by 3%, or 4%? Mathematics won’t help, and there is no magic number. These situations in fact occur due to a number of mechanisms that get triggered once we pass a certain but very hard-to-predict threshold, and then become self-sustaining. This is what happens in an inflationary regime. Once we move beyond a variable rate of inflation based on a country’s circumstances, agents, in a desperate attempt to protect their purchasing power and profits, try to index their salaries or prices against each other, thus spiralling into a self-inflicted and self-sustaining vicious circle.

However, the only way that inflation can feed itself and continue to grow is if money supply increases simultaneously, thereby providing the necessary fuel.
The reason why it is important to stand fast in the fight against inflationary regimes, is because they undermine our very trust in contracts, which are essential for the economy and for growth, be it commercial contracts setting the price of goods and services, employment contracts, or contracts for receivables and debts. These contracts, which underpin our ability to prepare for the future and set our expectations by giving us reasonable confidence in the situation, can only function effectively if prices remain stable. On the other hand, a low rate of inflation i.e. not high enough to trigger the problems caused by indexation, is entirely acceptable, and highly preferable over any form of deflation.

So, where are we today? The first thing to note is that, despite sustained growth in global liquidity and marked rises in raw material prices since around 2003, especially oil whose price has roughly tripled, inflation is currently very well contained. Excluding energy and agricultural products, it is hovering at around 2.3% in the United States and 1.6% in the eurozone, and if we include the full range of products in the price index, it is at 3.5% and 2.4% respectively. What have been the main reasons so far behind this price stability? First, the arrival of several emerging countries onto the global economy, some with huge populations, which has had a powerful anti-inflationary effect. Their labour costs are significantly lower than in OECD countries and their heavy investment in industry has not only introduced fierce competition for traditional industrial countries, but has also resulted in excess global production capacity, since their domestic consumption is not experiencing the same rate of acceleration.

The result has been terrific downward pressure on industrial prices, and an inability of companies to pass on the rise in the cost of raw materials. However, against all logic, this has not led to a fall in profits. Quite the contrary, since profits as a percentage of GDP have remained at historically high levels in both the USA and the eurozone. They have even risen here and there. This is due to the second factor behind the price stability situation.

On both sides of the Atlantic, companies have been able to guarantee high profit margins, because they have been giving their employees less purchasing power than they are making in terms of productivity gains. Since 2003, annual per capita productivity in the United States has been above 3%, whilst real wages per capita have fallen each year by around 2%. In the eurozone, productivity gains have been around 1%, whilst purchasing power has virtually stagnated. Once again, the pressure caused by the burgeoning power of emerging countries and their impressive workforce reserves have not translated into any great negotiating power for American employees and even less for their European counterparts, who are experiencing much more sober growth and a much higher rate of unemployment. These figures are of course all averages and encompass a broad range of realities, especially if looking at one particular European country or separating the services sector from industry.
So what next? Will the same causes have the same effects?

We are already seeing record high levels of production capacity usage in America, and salaries are beginning to stretch. More jobs are being created, with unemployment remaining low, all of which is gradually nudging prices upwards. The financial markets are watching the situation very closely. But will America still be growing this fast by the end of the year? More structurally, if the increase in raw material prices continues, especially for oil, will the anti-inflationary effect of global excess production capacity – which is in fact falling due to healthy global growth – and of very low labour costs in emerging countries continue to counter the effect of the rise in raw materials?

And if companies, especially industries, in OECD countries, fail to recover all, or even just some, of their ability to control their prices due to competition from emerging countries, can they continue to generate huge productivity gains, above the rate of increase in real wages? Can they therefore protect their profits? Will the positive effects of the current technological revolution in terms of productivity gradually fade? And will the negotiating power of employees recover in the long-term? In fact, without greater power to control their prices, unless companies are able to maintain the current balance between productivity gains and real wage increases, the only possible outcome is plummeting profitability. If, on the other hand, they do recover a greater ability to set their prices, then for the exact same reasons they will attempt to protect their profit margins by bumping up their prices, thereby encouraging inflation.

It is therefore important to keep a close eye on all these factors, to determine bit by bit whether the sudden hike in raw material prices could trigger a new inflationary regime. In the meantime, and knowing the risks, we are betting that the effects of globalisation and those of the technological revolution that began in the 1990s have not yet run their course, and that the habit of price and salary indexing is not about to resume, despite the likelihood of a small mechanical increase in inflation. The new few years will therefore depend on the rate of growth, and therefore of employment, and on profits, and therefore on the markets.

CEO of BRED – Professor of Financial Macroeconomics and of Monetary Policy at HEC