The Fed’s Blindspot on Global Inflation Drivers


What is causing the rise in inflation and how are central banks scrambling to get their hands on it?

China: a “one country check on global inflation”

In “Monetary policy in the grip of Pinscher movement,” Claudio Borio et al. discuss how the effects of globalization, particularly China’s accession to the World Trade Organization (WTO) and the collapse of the Soviet Union increased structural deflationary pressures, which were more than a domestic inflation catalyst in advanced economies :

“A likely candidate is globalization, especially the entry into the trading system of former communist countries and many emerging market economies that liberalized their markets – countries that, moreover, tended to resist exchange rate appreciation. As elsewhere and (Borio (2017)) in more detail, the entry of such producers more prominently is likely to weaken the pricing power of firms and, above all, labor, making markets more competitive. During the cost-convergence process, this will result in persistent deflationary winds, particularly in advanced economies, where wages tend to be higher. If so, then at equilibrium, growth in the real economy has exerted a persistent downward pressure on inflation. may have poured in, possibly exceeding the cyclical effect of aggregate demand.

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Monetary policy is effective in combating cyclical shortfalls – such as market volatility following the financial crisis – but ineffective against structural changes. However, key monetary officials nonetheless explained structural deflationary pressures from the integration of China and former Soviet states into global value chains (GVCs) – a long-lasting structural shift – as indistinguishable from cyclical weakness resulting from short-term disruptions. .

This contributed to central banks’ asymmetrical policy response that eases aggressively but tightens timidly, as long as inflation remains below the target, agnostic to structural versus cyclical reasons. As Borio et al. Write:

“The second factor is an asymmetrical policy response to successive financial and business cycles in the context of the prevailing deflationary tailwind associated with globalization. In particular, the asymmetrical responses are in evidence as evidenced by the financial boom and bust of the 1980s-90s and that surrounded the GFC. As long as inflation remained low and stable, there was no incentive for central banks to tighten policy during the fiscal boom, which in both cases was preceded by financial stress. But to fight aggression and avoid any deflation. There was a strong incentive to react aggressively and consistently to avert danger.”

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Under this policy background, a structural deflationary factor that has been interpreted as a cyclical reduction called for an aggressive monetary response, as well as timid and delayed policy tightening on follow-up. Persistently low interest rates activated low productivity sectors such as real estate and accelerated misallocation of resources (misuse) and “contributed to the spread of”zombie“Company.

Actually, Confluence of structural and cyclical inflation drivers China has been turned into a significant quantitative easing (QE) enabler by central banks, however.A Country Check on Global Inflation“The latter has attracted more and more market attention.

Chinese producers pass higher prices down amid cost escalation.

After acting as a “reducer of global inflation” for nearly two decades, Chinese producers faced a perfect storm of margin compression in the first half of 2021 amid concurrent supply constraints and a demand rebound. As David Qu, a former People’s Bank of China (PBOC) official and Bloomberg economist, observed, volatility in global commodities from crude and iron ore to copper – together accounted for 70% of movements in China’s producer price index (PPI) Accounting – pushed input costs to record levels.

Such cost escalation later Policy responses designed to curb price rise. Macro investors are acknowledging the continued rise in US import prices on goods coming from China, even as many disagree with the efficacy of price control measures or the dollar’s rebound prompted by the US Federal Reserve’s sharp reaction to cool steady-buoyant commodities. will do it or not. Market.

The rise in US import prices is comfortable: Chinese producers cannot indefinitely act as the world’s inflation gatekeeper amid high input costs. While some observers, Qu among them, maintain that the price absorber effect persists, higher realized import prices support the thesis that rising input costs have offset the effects of inflation.

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China’s less effective “inflation mitigation” capability could lead to a fundamental market shift if the Fed and other major central banks stay with the current framework and do not make structural distinctions from cyclical inflation catalysts.

under a successful price control campaign by Chinese regulators and Weakness in global commodities has resumed on the strength of the dollar and the spirit of the Fed, China’s producers could resume export deflation and contribute to convergence as the Fed projects a “transient” inflation outlook. However, it does not break new ground on asset valuation.

Conversely, failed price controls by Chinese authorities and the continued strength of the commodity could increase pressure on Chinese producers and lead to greater inflation pass-through for advanced economies. Few investors have any risk management experience amid increased inflation, and a departure from dovish Fed policy, or asset prices may be bearish towards policy sponsorship, riskier assets and government bonds alike (risk-parity complexes). and bearish for leveraged strategies).

The Fed may change course and consider pass-through inflationary pressures from China as “structural” in nature and determine that it does not warrant a policy change. But it would potentially invite public scrutiny and increase political risks, especially since former Fed officials hold key government roles and lead influential research institutions. Thus, some may interpret amendments to previous policies as admitting to “policy mistakes”.

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Market participants face asymmetric risk rewards: positioning for a return to low-inflation conditions and relying on China to remain an “inflation black hole” to justify long-term policy adjustments, or the inflation regime Anticipating changes that increase uncertainty in major asset markets. The likelihood of these outcomes is roughly the same, but the status quo scenario could result in muted asset price appreciation, while more persistent inflationary pressures could lead to a significant bearish re-pricing of “policy-backed assets”.

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All posts are the views of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image Credits: © Getty Images/DavidFillion

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Victor Xing

Victor Xing, Kexelias, Inc. and is a former fixed-income trading analyst at Capital Group Companies, focusing on monetary policy, inflation-linked bond and interest rate markets.

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