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Inflation Drivers in the Medium Term

Concern about inflation has weighed heavy on investors’ minds over the past few months as economies around the world increasingly look to roar back to life, driven by historically unparalleled levels of stimulus and record levels of saving. However, much of this discussion regarding inflation has focused on short term drivers. More relevant to markets are two trends which could cause rising prices for several years to come – the greening of the economy and individuals beginning to negotiate wages rises once again, rather than just accept the offered rate.

Whilst an increasing focus on the carbon footprint of firms and countries has been occurring for many years, it is likely that the start of the current decade will be seen in history as a turning point in that discussion. Indeed, it is now abundantly clear that, rightly or wrongly, corporations around the world are placing greater emphasis on acknowledging and reducing their climate impact, regardless of its impact on profitability. Nothing shows this more starkly than Goldman Sachs, the archetypal profit focused organisation announcing on 4th March 2021 that it would seek to make its operations carbon neutral by 2030 and its financing activities carbon neutral by 2050. Whilst it is hard to pinpoint a precise list of changes that will be made by Goldman and other firms with similar targets, it is clear these greening efforts will come at a cost be they operational changes or just buying offsets. Beyond these voluntary measures, it seems likely that governments attempting to fund the larger state which the pandemic has brought in many countries will turn to carbon taxation as a politically palatable way of raising funds. Hence, the efforts of both business and countries to enhance their green credentials will inevitably lead to higher costs for firms and, in time, higher prices for consumers. This will not be in the form of a one-off spike, but a prolonged upward pressure on prices over decades to come.

Currently inflation is showing signs of rising due to shortages and demand pressure, these factors can be expected to recede as supply chains recover and demand stabilises. Faced with this environment, firms are slowly looking to raise their prices to reflect higher input costs, whilst there is also great potential for price rises to manage demand. However, history has shown that vital to a prolonged period of elevated inflation are increasing wages which in turn fuel further inflation. This pressure to increase wages has long been absent in large swathes of the economy, in part due to the prosperity of so many in Western economies. This has been a major factor contributing to over a decade of stagnant wages in countries including the UK. A shortage of talented individuals from plumbers to coders means that many are in a strong position to negotiate wage increases; however, decades of low inflation have produced a generation unfamiliar with the notion of asking for a pay rise. Indeed, many are surprised when leaving a firm that they are offered a pay rise to stay, leaving them wondering why they had not pushed for a pay rise sooner. The strength of corporate profits over the past few decades (excluding 2008/09) can in part be attributed to this timidity of workers in asking for a pay rise. However, if people learn how to ask for a pay rise, it could be the missing link which turns a period of elevated inflation into an inflatio

nary spiral. A 4.8% rise in weekly earnings in the three months to January 2021 in the UK suggest that this change may be beginning to take hold.

Whilst it is true that most of the inflation seen over the next couple of years will be due to disruptions caused by the Covid pandemic, this is likely to trigger a shift in mentality from many workers who learn how to ask for a pay rise. Rising pay has been the missing link in the inflation spiral and, once formed, will likely be hard to break. Alongside this, a fundamental pivot in the aim of companies and countries away from minimising cost of production will come at the cost of a continued upward pressure on prices as cheaper methods of production are shunned and more money is spent on greening efforts.