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It’s not inflation that will ‘transition’. It’s everything else.

George Lagarias
George Lagarias, Chief Economist at Mazars

George Lagarias, chief economist at Mazars, comments on the Omicron variant, inflation and central banks.

“The Omicron variant was not much of a surprise. We have already seen many mutations of Covid-19. But a hawkish Fed? We haven’t experienced one since 2018. As the potential of a new outbreak emerges, Fed Chair Jay Powell surprised markets by insisting that the US central bank would accelerate asset purchase tapering in December. Instead of customarily intoning the ‘Fed Put’, as per usual in times of crisis, Mr. Powell added fuel to the fire, causing stock markets to retreat on Tuesday. As our current investment thesis is underpinned by the perma-dovishness of central banks, we have to examine what this means for our portfolios.

The pandemic isn’t going anywhere

“But first, let’s start with the pandemic, the undisputed driver of economic activity in the past twenty-four months. Almost two years into it, we have now reached the 15th letter of the Greek alphabet’s 24 letters. Interestingly, ‘Nu’ and ‘Xi’ which precede Omicron were skipped; the former because it sounds like ‘new’ and could cause confusion and the latter because it is a homonym to the Chinese President’s last name. That means thirteen distinct variants have been uncovered in the past twenty four months, slightly more than one every two months. Even before Delta took the world by storm, promising to imperil the second Christmas season in a row, the world woke up finding it has to contend with another, potentially much more transmissible variant. At this pace, there’s a decent chance that the Greek alphabet will run out of politically acceptable letters before the pandemic is over. Or, to quote the eminent Dr Fauci: “We will have to learn to live with Covid because we are not going to eradicate it”.

“If we are to take science’s words to their natural conclusion what does this mean? It means that global trade, retail and in fact the whole of the services sector will have to forego half-measures and ‘wait and see’ adjustments and firmly consign 2019 to history. The only reason the pandemic hasn’t left significant scars on the global economy is that we have refused to change the way it works. But persistently fighting a rising tide could cause permanent damage. Operations managers are approaching the point where they have to overhaul global supply chains and adapt them for a world with much less smooth demand patters, business travel, labour mobility and in-person services, including sales. Such a transition will inevitably disrupt the global supply chain system, super-optimised and calibrated for a way of life that may not be available anymore. As with any change process, it can’t be expected to go entirely smoothly. Add to this picture the price pressures from China’s transition into a more consumer-centric model, and supply inflation may be here to stay for some time.

No longer ‘transitory’

“On the face of it, then, it might sound wise and even timely that the Fed decided to drop ‘transitory’ from its vocabulary.

“True wisdom, however, does not come from optimising predictions, especially after the event. As any person over a certain age knows, it comes from accepting what one can’t control.

Milton Friedman, the Nobel laureate economist and intellectual leader of neoclassical economics, famously proclaimed that ‘Inflation anywhere and everywhere is a monetary problem’. Remove excess money supply from the system and demand comes back down to meet supply, stabilising prices, the theory goes. This tenet has been the bedrock of central bank policies in the era of Monetarism (post-1971). On this aphorism, and Paul Volcker’s success as Fed chief in the 80s, central banks were given extraordinary powers and independence in order to fight inflation. Their basic tool? Interest rates. To reduce the excess supply of money, policymakers just had to make it more expensive.

“The model may work well for demand-driven inflation. If cheap credit boosts demand, then expensive credit would suppress it. But what we are experiencing is not demand-driven inflation. Prices go up because supply chains are broken, creating a vicious circle where the uncertainty of delivery causes buyer behaviour to become erratic (ordering outside normal patterns), further destabilising supply chains and so on.

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