Cheng Shi is the Chief Economist and Managing Director of ICBC International, and a director of the China Chief Economist Forum; Zhang Hongyan is a senior economist at ICBC International
"Life is easy to end, and the world is impermanent and bad." On August 27, Fed Chairman Jerome Powell continued to express a firm stance on the unsustainability of current inflation levels at the Global Central Bank Meeting. Specifically, he gave five reasons why the current high inflation level is unsustainable: first, the current high inflation will not affect the broad price level; second, the current price growth rate of some high-inflation projects has begun to slow down; third, wages do not pose a threat to medium- and long-term inflation levels; fourth, long-term inflation expectations remain stable; and fifth, the long-term characteristics of the global economy will suppress long-term inflation levels. However, according to our research, these five reasons lack sufficient and empirical support. First, the prices of goods or services severely affected by the epidemic may be transmitted to affect the price levels of other goods (services); second, if the epidemic is repeated, the prices of some goods or services may not be able to fall smoothly with the end of the epidemic; third, considering the non-linear relationship between wages and unemployment, wage growth may accelerate in stages; in addition, under the influence of fiscal stimulus, short-term inflation expectations and real inflation may be transmitted to the upside of long-term inflation expectations Finally, the global economy's ongoing role in long-term inflation levels is marginally weakening.
High inflation or transmission affects a wide range of price levels
Fed Chairman Jerome Powell believes that the current high inflation project mainly focuses on goods and services that have been seriously affected by the epidemic. These high-inflation items include food, energy, new and used cars, car rental, tourism, and transportation. Some research institutions have further excluded these high-inflation items based on core inflation rates and found that the current price levels of goods and services that are less affected by the epidemic are not widely transmitted. For example, the U.S. headline inflation rate (CPI) for June-July was revised quarter-on-quarter at 0.9% and 0.5% respectively, and excluding items that were highly related to the epidemic, inflation was 0.25% and 0.05% month-on-month.
However, our research has found that the impact between high-sensitivity inflation programs and low-sensitivity inflation programs in the post-pandemic period is intensifying. Specifically, we used a quarter-adjusted overall month-on-month inflation rate (CPI) in the United States and excluded the highly relevant project inflation rate (excluding food, energy, used vehicles, shelters and transportation) to find that the causal relationship between the two has strengthened after the epidemic (Figure 1). From a detailed point of view, the energy and transportation items that have been more affected by the epidemic have a significant impact on the clothing and housing items that are less affected by the epidemic (see Appendix 1).
In addition, a Bayesian time-varying vector autoregressive model (B-TVP-VAR) is constructed in this paper, which selects the peak period of the outbreak in the United States to observe the transmission impact that the price of high-inflation projects may have on the price of low-inflation projects. Our model-based empirical findings show that higher-sensitivity inflation projects (such as energy and transportation) can significantly impact major less-susceptible inflation items (such as housing, clothing, medical monitoring, and entertainment spending) within six months. However, if the epidemic is repeated, the high inflation project may further have a superimposed transmission impact on general services and commodity prices.
With the end of the epidemic, the prices of some goods and services will not necessarily fall at the same time
The outbreak of the epidemic in Europe and the United States has exacerbated the rapid rise in the price level of goods and services at the production end due to supply bottlenecks. When the epidemic in Europe and the United States was controlled, we found that the prices of major goods and services did not smoothly achieve a synchronous decline. On the contrary, the strong demand side will begin to support the continued high prices of goods and services. In addition, judging from the current epidemic situation, there is still uncertainty about when the epidemic will be completely controlled, and it is difficult to conclude that the high prices of goods or services will be able to fully adjust and fall quickly in the short term with the recovery of supply capacity.
Another reason that has prevented prices of goods and services from falling in tandem with the end of the pandemic is global supply chains. Specifically, the recovery of global supply chains is likely to take longer than the market expects. At present, the impact of the epidemic on the industrial chain is gradually evolving from temporary and partial to long-term and systematic. First of all, in the global value chain, the countries seriously affected by the epidemic provide more than 60% of the global intermediate goods and capital goods, and the upstream and downstream relationships between these countries in various industrial chains are uncomplicated. If any major manufacturing country stagnates in the intermediate production link, the entire industrial chain will be affected. Therefore, we believe that the recovery of the global industrial chain may take longer. The increase in recovery time means an increase in trade costs along the value chain. Second, in the face of the impact of the epidemic and geopolitical impact, the three countries with China, the United States and Germany as the core of the value chain are trying to re-establish their own intensive regional value chains by using their own manufacturing advantages. However, building intensive regional value chains is difficult in the short term. The transformation of global value chains to regional value chains means that the allocation of factor resources (such as capital, labor, data, technology) will affect the transaction costs along the value chain. For example, the central congress of the value chain has begun to strengthen and centralize the protection and use of domestic data, which has increased the cost of obtaining global data. In addition, the return of manufacturing and labor to developed countries in Europe and the United States will also increase labor costs.
Wage growth is likely to accelerate
In theory, a nominal GDP increase will lead to a recovery of the employment gap, a strong employment demand will further drive up wage levels, and a spiral of wage levels will drive the overall inflation rate upwards. With the recovery of the epidemic, jobs in the U.S. labor market have increased. But remains weak due to labor force participation growth, which will lead employers to raise their wages further to attract more employees to fill the job gap. During the recovery period, as Fed Chairman Jerome Powell has argued, wage growth really doesn't threaten long-term inflation. However, as economic activity continues to expand, wage growth is likely to affect the acceleration of overall inflation.
According to our study, although the Phillips curve began to flatten out gradually after 2015 (Figure 4). But as long as unemployment and inflation remain negatively correlated, it's hard to argue that the Phillips curve has failed (Figure 5). Similarly, from the slope of the wage Phillips curve, there is still a significant negative correlation between wages and the employment gap (Figure 6).
Based on the nonlinear characteristics of the Phillips curve, wages will rise in stages as the employment gap gradually decreases, and our model better fits the nonlinear change between wages and unemployment rates (Figure 7). Therefore, there is reason to believe that the accelerated rise in wages will support the continuation of high inflation.
Rising wages will also affect the impact of consumer spending on core inflation levels. Our study found that the impact between U.S. consumer spending and overall price levels is intensifying after the pandemic (Figure 8). This means that the growth of workers' wages can not only affect inflation expectations, but also more effectively transmit the actual inflation level through household consumption expenditure. Finally, wage prices are sticky in the short term. Although the continued recovery of the labor market with the opening of the economy will bring wage levels closer to equilibrium levels, wage rigidity may support some inflation projects to further maintain their higher price levels in the short term.
The transmission of short-term inflation and real inflation to long-term inflation is complex
Looking at the term structure of inflation expectations, despite the Fed's confidence that broad inflation expectations remain stable at present (Figure 9). However, there is still uncertainty about the transmission effect of real inflation rates and short-term inflation expectations on long-term inflation expectations. Here, we have mainly considered the possible impact of fiscal policy on short-term inflation expectations and real inflation. We believe that fiscal stimulus may affect short-end inflation expectations and real inflation rates, thus transmitting the rise in long-term inflation levels.
Specifically, the Biden administration is trying to push hard with its fiscal package to support the U.S. economy. On the one hand, the $1.2 trillion infrastructure bill, which covers eight years, is expected to pass by September 27. Biden's tax overhaul proposal, on the other hand, is expected to generate $1.3 trillion in net federal revenue for the U.S. Treasury over the next 10 years (2022-2031). Based on the current Fed benchmark forecast for U.S. personal consumption expenditure (PCE), if the U.S. government initiates proactive fiscal policy to support U.S. infrastructure investment, then under the effect of fiscal stimulus, we expect the short-term real inflation level to increase, and the real inflation and short-term inflation expectations will be transmitted to the upward trend of the long-term inflation expectations in the United States (see Table 1).
Factors such as information technology, labor factors and global integration are dampening inflation
First, the standardization and compliance of the Internet and fintech industries will increase transaction costs along global value chains. Around the factor data, the development of a new generation of information technology represented by artificial intelligence, big data, cloud computing and the Internet of Things has large-scale reduced the intermediate cost of Internet companies in the global value chain, and the natural monopoly of the Internet and the extremely low marginal cost expansion have rapidly increased the concentration of industrial and financial capital, thus further exacerbating the gap between the rich and the poor in society. With the gradual control of the epidemic situation in major economies around the world, governments and relevant regulatory agencies around the world have begun to put forward more normative and forward-looking requirements for the development of Internet technology companies. Specifically, the standardization and compliance of Major Countries in the world's Internet technology giants in antitrust, data security, and financial technology supervision will increase the transaction costs of Internet companies in the global value chain.
Second, de-globalization will increase the cost of production, manufacturing, trade, institutions and financing in the industrial chains of various countries. Affected by factors such as the widening gap between the rich and the poor and the rise of populism, the global economy is transitioning from integration to de-integration. If regional value chains can replace part of the role of global value chains, we expect this to increase the cost of production and financing on the global value chain. The rise of trade protectionism has led some countries around the world to erect trade barriers, and tariff increases and non-trade barriers will increase trade and institutional costs, thereby driving up overall inflation.
In addition, as a global manufacturing center, China's labor market structure is undergoing profound changes. The aging of the Chinese population is intensifying, which will lead to a further acceleration of labor costs, which can be transmitted to the US consumer price level through import and export trade.
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