We have been hearing for months now of a rocketing and persistent inflation, contrary to what was expected a little over half a year ago. In this period, a war has begun in Europe that has affected the price of many raw materials and additionally distorted supply chains, still highly affected by the consequences of the pandemic. Making forecasts in this situation is quite a risky task, especially since the level of uncertainty is enormous. It is worth remembering that one of the most demanded consultancies in recent months by large multinational companies is the generation of scenarios for the possibility of a war in Taiwan.
But what if inflation wasn't so persistent? What if the pendulum had swung too far from absolute transience to absolute persistence? There are several arguments that seem to indicate that there is a high probability that inflation will moderate in the second half.
First, there is the base effect. Energy prices started to rise in the second half of 2021 and, therefore, when we compare with that period, annual inflation will decrease by construction.
Second, expectations of a slowdown in the economy have a soothing effect on commodity prices even before the break has occurred. In the last month or month and a half the prices of oil, wheat, palm oil, cotton, copper, steel, platinum, etc. have fallen significantly. In fact, the price of oil has already returned to the value before the start of the Ukrainian war. Only the price of gas and especially coal has continued to rise. These falls in the prices of raw materials are good news, although the appreciation of the dollar takes some of this deflationary impulse away from the countries of the euro zone.
But let us suppose for a moment that these two effects were not enough to stop the inflationary spiral. Suppose, as is very likely, that Russia kept the transit of gas through the Nordstream 1 closed. Given the gas reserves accumulated by the European countries most dependent on Russian gas, this would cause supply problems and potentially supply cuts, making a much more likely recession in Europe. In addition, as we have seen on many occasions in recent decades, social unrest is normally related to energy shortages or rising fuel prices. In this case, the EU would put pressure on Ukraine to accept new borders with Russia in the west and south, in exchange for offering it money for reconstruction and quick access to the Union. The end of the war would reduce the price pressure of many raw materials and rebuild, albeit slowly, supply chains. At first, there will surely be some aversion, or even a formal veto, to buying Russian gas or oil, but the situation will normalize by force of events.
It is true that in addition to the temporary effects on inflation of the increase in the price of raw materials, there is a structural effect associated with a certain deglobalization and the increase in cost associated with considering the possibility of breaking the supply chain in networks of complex providers spread across many countries. In addition, the need for redundancy in providers to mitigate problems similar to those observed in the last two years will also mean an additional cost that will be passed on to prices. But the structural part contributes little to the inflation we currently have.
The most important danger is the setting in motion of a wage-price spiral and the increase in inflation expectations among economic agents. These effects are already clearly visible in the United States and require a sharp rise in interest rates. However, this situation still does not exist in most of Europe. And taking into account that it will be the most affected by the consequences of the war and that inflation could moderate before inflationary expectations are fully de-anchored, interest rates are not expected to reach very high levels. Furthermore, the inversion of the yield curve (long rates lower than medium-term interest rates) indicates that we are headed for a recession that will require us to be very cautious with interest rate hikes.
The evolution of inflation and growth prospects are undoubtedly related. For example, the latest survey of German investors shows that sentiment is at its lowest since 2011, one of the most cited causes being the price of energy and the foreseeable increase in interest rates by the ECB. Even considering that inflation will subside in the coming months, it is important that it falls fast enough so that it does not continue to affect the expectations of economic agents and increases the probability of entering into a spiral of wage and price rises. The problem is the delays with which changes in the price of raw materials are transmitted to the products. For example, in the case of the price of oil, it adjusts very quickly upwards, but gasoline takes time to pick up falls. The falls in the price of oil must also moderate the prices of derived petrochemical products (nylon, rubber, plastics, etc.), which are at all-time highs.
In the end, as almost always in economics, everything depends on the agents' expectations: recession expectations influence the prices of raw materials, which include inflation expectations that influence banks' interest rate decisions and the wage demands and prices of the companies that, in turn, alter the expectations of inflation and the probability of recession.
Unfortunately, economists still do not know how to measure in a useful way, in predictive terms, the evolution of these expectations. The "animal spirits" continue to resist economic measurement.
