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Why We Believe Inflation Is Transitory

Published 10/25/2021, 08:25 PM
Updated 07/09/2023, 06:31 AM

In the past year, inflation has been a significant concern for governments, central banks, and financial markets. This led the central banks in developed countries to start planning for tapering. The Fed is considering starting tapering purchases in November 2021.

During the pandemic-induced lockdowns, the Fed and the European Central Bank (ECB), to support the economy, increased their monthly security purchases, a process called Quantitative Easing (QE). Thanks to central banks' actions and governments' interventions to support workers, the economy and financial markets have survived this hurricane.

We can even say that the economy looks healthy today in developed countries, and many believe that demand has never been that vigorous. Employees who could not work in the USA and Europe benefitted from government support and received aid almost equivalent to their wages.

On the other hand, their spending was limited by the lockdowns. When the economies reopened, demand came very strong because of a pandemic-driven frustration and accumulated savings.

On the other hand, supply chains were critically disrupted by COVID-19. This, coupled with the strong demand, has led to higher inflation. This inflation was a result of a disequilibrium between a weak supply and a strong demand.

But demand has been fading away since. In the USA, the velocity of money, which measures the rate at which money is exchanged in the economy, increased from 1.1 end of second quarter 2020 to 1.147 end of third quarter 2020, in sync with the reopening of the economies. However, it has been in a downward trend since.

Today, inflation is not the result of strong demand but weak supply that struggles to produce and fulfill customers' needs. Supply chain disruptions will eventually come to an end.

When we reach equilibrium, as long as globalization remains intact and renewables do not lead energy prices to rise, competition will surge, prices will fall, and margins will narrow for certain businesses, compensated by volume.

We believe that accrued competition in our increasingly globalized world is one of the reasons why inflation has been decelerating the past decade. Globalization is not in jeopardy today.

Another reason for disinflation and the decrease in money velocity is that developed countries have an aging population. This is even more pronounced in Europe. Birth rates have been decreasing and life expectancy has been increasing.

In 2050, Europe is projected to count as many inhabitants as it has today. However, the population will be aging, and the active population, the one that works or seeks to work, will fall dramatically.

In the USA, the population could increase by 2050, but this will not outbalance the aging population, and active people are forecast to be fewer. We believe that this will lead to deflation, and central banks will have to use their tools to boost demand in the future.

In this future, the decrease of the active population will be compensated by advances in scientific research in artificial intelligence, automation through robotics, and other innovations.

As highlighted by Cathie Wood, this revolution should result in even more deflation as the need for human capital will decrease, and companies will use specific tools to improve operational efficiency.

What economist Schumpeter called "creative destruction" implies that lost jobs will be replaced by new ones emerging from innovation.

However, we believe that those jobs will not be replaced, and aggregate demand will fall, dragging down the consumer price index.

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