EfTEN CapitalEfTEN Capital


Anatomy of price increase

Obviously, something has changed in international economic life in the last two years, and it seems that the winds blowing in the financial world are changing it even more. Namely, after more than ten years, once again the developed world is facing rising consumer prices, known as inflation, like it has not seen for more than a decade. Life has taught me that the memory of financial market participants amounts to a maximum of 10 years. I dare say that the bigger the flow of information available via the Internet, the shorter people’s memory. Being exposed to a daily waterfall of information is equivalent to a fire hydrant ejecting information 24/7, and it is difficult to absorb this so-called helicopter view. However, in today’s situation we must forget about the daily newsfeed noise and look from a distance. What does this situation mean for us? It is worth entertaining the idea that history will guide us to the future, but we must never think that things will be different this time. We know from the past how this bold idea became expensive to market players, be it the dotcom crisis of the 2000s or the financial crisis of 2008. Changes that have taken place in the world’s financial systems over the last decade are simply so unprecedented and far-reaching that it is worth thinking more broadly than dogmatically.

Inflation is present and does not intend to leave

Dear fellow travelers, inflation is back whether we like it or not. For central bankers, it’s like a family feast that is visited by a relative who is obviously annoying the family and who was invited just for the meal. Unfortunately, he has overstayed his welcome. After a few extra shots, he hijacks the discussion and has no intention to leave. In other words, the hope that inflation is temporary is fading every day. For central bankers, the situation that has arisen should, in militaristic terms, mean that they will blow the horn of war and start a general mobilization. Inflation – their archenemy – is showing signs of life after more than a decade of silence. However, the problem is that central bankers have tied their own hands during the last decade of “peacetime”. Thus, they are struggling to combat the enemy that is amassing forces on the horizon.

According to financial markets estimates, the ten-year average expected inflation in the United States is currently 2.5%. The last time the figure was so high was in 2006, only at that time the US Federal Reserve’s interest rate was 5% – today it is 0%. Ten-year inflation expectations in the euro area are at around 2.0%, which is in line with the European Central Bank’s expectations, but they are still set to rise in the near future. Yes, of course, the main reason for this year’s high inflation is last year’s low base, but it is wishful thinking to assume that next year the problem will resolve itself. For economists, inflation is at a reasonable level if the general public does not notice it or hear about it on a daily basis. In the Estonian context, this means if national TV news (Aktuaalne Kaamera) does not give the topic of inflation much air time. Today, we have reached a point where it is impossible to ignore the rise in consumer prices, which is hitting the low-income population in a particularly painful manner. This in turn affects people’s political preferences and choices.

It has been much debated why we did not have inflation in the last decade, when there was good economic growth everywhere in the developed world and central bank printing presses were in full swing. It must be made clear that inflation was widespread, even pandemic, but in concerned asset prices, not consumer prices. We understand the latter to be classical inflation, because as we know, consumer price indices do not include a component of rising asset prices – central banks’ “bored money” circulated aimlessly in the financial markets without finding its way into the real economy. The main reasons for the lack of inflation can be divided into four categories:

  1. Demography – in an aging society, which applies to the entire developed world, the share of pre-retirement people in the labor market is increasing. Their expectations and pressures on wage growth are often lower than those of younger people. This keeps labor cost growth low across the economy;
  2. Global free trade, where supply-side factors such as production costs were increasingly able to move to cheaper countries as prices rose, thus keeping supply-side price pressures in check;
  3. Internet and e-commerce – whereas in the past, for example, you had to go to a central sports shop in your town to buy sports equipment, now the whole world is open and offering great deals that a home sports shop can’t offer;
  4. In the absence of inflation, workers who were organized in trade unions did not have the position to negotiate for rapid wage increases, which would have stimulated the economy’s demand side.

China once again shattered the illusion of Western think tanks

In the post-pandemic world, these structural changes will remain largely the same, perhaps excluding the return of global free trade. Of course, all eyes are on China, which is currently the global production facility or ‘world’s factory’, and is increasingly threatening the stability of world peace. Now, it has focused its attention on Taiwan. The issue of Hong Kong’s autonomy has largely been “resolved” from Beijing’s point of view, no matter how concerned the European Commission’s spokespersons may be. It isn’t really a surprise, but rather another example of the illusion of Western think tanks being shattered. After all, when China became a member of the World Trade Organization (WTO) in 2001, optimists assumed that the country would abandon communism and would happily step into the family of democratic rule of law. No country with a fast-growing economy could eternally repress its citizens, because the latter are craving, even demanding, freedom – promised various think-tanks. Over the last few decades, China has proven the opposite with the stubbornness of a ram. The Orwellian population monitoring system, the harsh fates of the Uighurs, the silencing of Hong Kong’s democracy and the Communist Party’s icy grip on the throats of technological giants tell us something much more unpleasant.

In the meantime, we can comfort those investors, including yours truly, who missed the rapid rise in tech stocks by admitting that the same happened to the big and powerful Chinese Communist Party, which did not realize the growing power of technology companies, before they put the top of the power ladder under pressure with IT innovation – by offering people new services that were no longer under the control of the central system. However, as the Chinese do, they woke up and quickly turned over subordination of the technology sector to the central government. When in late 2020, the Chinese central government placed regulatory barriers on the stock exchange debut of Jack Ma’s Ant Group, it was very easy to draw parallels to the start of the demolition of the former Yukos company in Russia. For the first time, ‘The Yukos moment’ of our great eastern neighbor gave a serious signal of Putin’s intention to establish a power vertical, and the same can be said of the intentions of the Central Committee of Xi Jinping’s party in light of the events surrounding Ant’s stock market debut. To sum it up, the ideal of the end of history is destined to die, until realists once again feel the real order of things. We know from the history of the fall of civilizations that the beginning of the end has always started by closing off from the rest of the world, by restricting free trade and personal freedoms. We will see if China follows the path of the Ming Dynasty in the 16th century.

Production is becoming more expensive due to the relocation of the “world’s factory”

After all, the United States as the hegemon of a democratic state system must respond to China’s rise despite its internal divisions, although the confrontation with China unites both Democrats and Republicans. While President Obama was speaking on the subject rather than taking real action, the Trump administration, chaotically as was common in this period, started vigorously to restrain China. That is why the Biden administration has inherited from its predecessors fertile ground for a more precise interpretation and implementation of China’s strategy. It is clear to everyone that verbal deterrence alone is no longer enough, because the fate of Taiwan – as a matter of keeping balance between the political forces of the South China Sea more broadly – is high on the agenda. Huawei was the first example of the US’s demonstration of power – of which Estonia was not untouched – but it is becoming increasingly clear that China’s internationalization is trying to be curbed every which way, especially in the new technology sector. There is also an unwritten message from Washington to business leaders: In China, it is worth being very careful and it is better not to do business there. The first retreats are already underway – technology giant Yahoo has announced its departure from China, and Microsoft is closing LinkedIn’s operations in China. For a flashback, Yahoo was one of the first foreign investors in Jack Ma’s Alibaba Group to invest $ 1 billion in Alibaba in 2005. Quoting a thought of the former U.S. Secretary of Defense Jim Mattis, “If goods stop moving across the borders, soon soldiers will move across the borders.” It is unlikely that the situation will become so tense, but in political power games, some miscalculations could lead to inevitable consequences, especially thinking of Taiwan at the moment.

As almost all international trade is largely based on the dollar, to the chagrin of leaders Xi and Putin, the eagle eyes of the US Department of Justice have enormous influence. In other words, if the transaction is made in dollars, the rule is that the transaction could be assessed by the US legal system if necessary. Let us recall the FIFA bribery scandals in 2015, where the only contact with the United States was the fact that the alleged bribe was in dollars. That did not stop the FBI from investigating. As tensions between the US and China continue to rise, it is wiser for companies to avoid China from the outset before potential US sanctions make one or another business relationship impossible overnight. The impact of the political tension on inflation and thus on the economy is obvious – it is intended to close the doors of the world’s factory or, at a minimum, force a change in its country of residence. Perhaps one of the cornerstones of the current low-inflation environment – China’s cheap production base – is changing the trend and new locations need to be found, which may be easier in theory than in practice.

The vulnerability of supply chains forces stocks to remain

Returning to inflation, Covid-19 restrictions disrupted supply chains. The graph of the price of transporting sea containers from China to the west coast of the United States is reminiscent of the exponential growth of the European natural gas price curve. This led all the advocates of a globalized trade network to think that it is better to bring supply chains closer to home – by favoring countries in the same political space and with a lower cost base than at home, but clearly more expensive than China. Recently, there has been a lot of talk about the European car industry, which is suffering from a shortage of microchips. The head of the Volkswagen Group summed it up by saying that we could have a car 99.9% ready, but that does not mean that we can hand it over to the customer. Overall, this means an increase in supply-side price pressure and higher production inputs. This development is certainly not temporary.

The corona crisis has also put under scrutiny Toyota’s famous production revolution – the “Just in Time” model – in which manufacturers maintain a minimum inventory, and all the necessary components from various subcontractors arrive at the factory line exactly at the right time. As the pandemic has created a need to increase inventories, this in turn means higher costs for producers and supply-side pressures for further inflation.

Of course, central bankers are very concerned about this, and for a good reason. The leaders of the European Central Bank have been travelling this autumn to Pan-European ‘financial fairs’ with a coordinated message that inflation is temporary and that worries will disappear next year. It is told to everyone, on every channel, to whomever is listening. The more aware people are about the mechanisms by which inflation occurs, the less they believe that inflation will fall rapidly. Of course, the low base effect will disappear in a year, but we know that the huge jump in energy prices will find its way into practically every product in the store. If high energy prices are receding and Russia is behaving responsibly from a European perspective – let me sincerely doubt this wishful thinking – it will not mean a drop in prices in shops. They may rise less in the future, but the price level, which the consumer is already accustomed to, is not destined to disappear if people’s incomes remain the same. Rather, wages are rising as wage pressures are on the rise everywhere in the developed world. In addition, the inflationary spiral is fueled from the demand side.

European sovereign debts cannot bear rising interest rates

The circle is complete and we are back to the central banks again. Yanis Varoufakis, a member of the Greek government at the time of the crisis and one of the most colorful finance ministers in Europe in the last decade, recently said that the European Central Bank should be at the forefront of the European green revolution. The prediction I wrote about two years ago in Edasi magazine (Viljar Arakas: MMT and GND walk into a bar) is quietly coming true. Given the strong political pressure on the Green New Deal, the US infrastructure plan and the governments’ continued spending spree, the world’s two major central banks, the Fed and the European Central Bank, need to come up with a solution for how to raise interest rates in the real economy while keeping central government borrowing close to zero. This would be the biggest manipulation in monetary history, meaning yield curve market distortion. Unfortunately, there are not many other choices. If Italy, whose central government debt constitutes 150% of the country’s GDP, would pay even one percentage point more interest, this additional cost would be equal to the size of Italy’s defense budget each year. This will never be allowed to happen politically – the situation is being acknowledged without excessive words in both Rome and Frankfurt. Hence, the European Central Bank must continue to buy government bonds, whether they like to do it or not.

Finally, and to think outside the box, the Fed has already made its green revolution with printing. Namely, the dollar is green and the print run goes into the trillions, more so in electronic form nowadays. If, in addition to the green revolution, central bankers would be required to print gender neutrality, the utopia of a progressive political agenda would be perfected. That last line of reasoning was deep irony, though, unfortunately, can no longer be completely ruled out. The ability of central banks to control inflation and be politically independent at the same time is outdated. The world has changed and we are changing with it. Inflation has come to stay for a long time. We might as well get used to it.


Viljar Arakas
CEO of EfTEN Capital

This website uses cookies. By continuing to use this site you agree to our use of cookies.
Please read our Privacy Policy.