- The Federal Reserve’s lack of awareness regarding factors influencing global inflation is coming to light.
- Globalization, particularly China’s entry into the World Trade Organization and the collapse of the Soviet Union, exerted structural disinflation pressure on advanced economies.
- Central banks misinterpreted structural disinflation pressures as cyclical weaknesses, leading to asymmetrical policy response.
- China’s producers, previously acting as global inflation dampeners, faced margin compression due to supply bottlenecks and demand rebound in 2021.
- The conflation of structural and cyclical inflation drivers by central banks turned China into a quantitative easing enabler.
- China’s producers passing higher prices downstream amid cost surge is eroding their inflation dampening effect.
- The Fed and other major central banks must differentiate between structural and cyclical inflation catalysts to avoid fundamental market shifts.
- If price control measures by Chinese authorities are successful, China may resume exporting disinflation and contribute to a convergence towards transitory inflation outlook.
- If price control measures fail and commodity strength continues, China may experience greater inflation pass-through to advanced economies.
- Market participants face asymmetric risk rewards – a return to low-inflation status quo or an inflation regime change leading to bearish re-pricing across policy-supported assets.
What is driving the surge in inflation and how are central banks misplaying their hand?
China: A “One-Country Check on Global Inflation”
In “Monetary Policy in the Grip of a Pincer Movement,” Claudio Borio et al. discuss how globalization, particularly China’s entry into the World Trade Organization (WTO) and the collapse of the Soviet Union, exerted structural disinflation pressure on advanced economies. This weakened the pricing power of firms and labor, making markets more contestable and resulting in persistent disinflationary winds. The central banks misinterpreted these pressures as cyclical weaknesses and responded aggressively to fight downturns but were hesitant to tighten policy during booms.
China’s producers, who previously acted as global inflation dampeners, faced margin compression in 2021 due to supply bottlenecks and demand rebound. Higher input costs eroded their inflation dampening effect, leading to a rise in import prices for goods originating from China.
Asymmetric Risks from Central Banks’ Inflation “Blind Spot”
If the Fed and other major central banks do not differentiate between structural and cyclical inflation catalysts, China’s less effective “inflation suppressor” capabilities may lead to market shifts. A successful price control campaign by China’s regulators and renewed global commodities weakness may contribute to a convergence towards a transitory inflation outlook. Conversely, unsuccessful price control and continued commodity strength may exacerbate inflation pass-through to advanced economies.
Market participants face asymmetric risk rewards – a return to the low-inflation status quo or an inflation regime change that increases uncertainty across major asset markets.
