Why international tensions do not risk a new increase in inflation

It’s an intriguing and slightly frightening thesis. Over the last 30 years, globalization has pushed down inflation around the world, as inexpensive imports from China have reduced the cost of clothing, toys, and technology for rich-country customers. But the world economy’s geopolitical fracturing is now jeopardizing all of that. Christine Lagarde, president of the European Central Bank, warned in April that escalating US-China tensions may harm value chains and raise global consumer prices by 5%.

Things aren’t all that horrible in reality. There is little doubt that a large dosage of disruptive widescale economic separation would have a negative impact on growth and boost prices. However, current geopolitical tensions are unlikely to be cataclysmic, and globalization (and, in particular, cheaper goods) has had less of an impact on inflation than intuition predicts. More alarming is the possibility that deeper global structural pressures will continue to raise costs for years, if not decades, to come.

The cohabitation of post-cold War globalization and the “great moderation” — low inflation and sustained GDP — appears plausible on the surface. In fact, however, economists have discovered only a minor correlation and instead, point to changes in monetary policy, decreased inflation expectations, and reduced wage inflation in line with prices.

Second, given that goods are far more widely traded than services, rising inflation differentials between the two would have been predicted. In fact, the disparity remained steady until the financial crisis, when services inflation declined but product inflation surged.

As a rough gauge of the impact of lower-cost Chinese imports, apparel, shoes, and electronics account for relatively modest portions of the consumer price basket. In the eurozone, garments, and footwear account for around 5% of total spending, compared to 15% for housing and utilities (using a restricted definition of housing costs) and 10% for restaurants and hotels.

Neither does the integration of the major middle-income nations always reduce inflation. It implies a growth in both demand and supply. During the 2007-08 global food crisis, one widely circulated narrative was that wealthier households in countries such as China were driving up commodity prices by eating more resource-intensive foods, notably meat.

This leads us to Lagarde’s caution. A 5% worldwide increase on top of existing inflation sounds ominous. However, upon closer inspection, the underlying estimations, while thorough and interesting, look more like a thought experiment than a real prediction.

In this situation, India, for example, is firmly in the camp of China. In practice, while New Delhi may be skeptical of the US and EU’s military and foreign policy support for Ukraine, it is highly improbable that it will join forces with a geopolitical foe like China, especially given India’s ambitions to export manufactured goods to Europe. Currently, the major emerging markets — India, Indonesia, and Brazil — are attempting to maintain their economic independence.

Furthermore, the projections are based on an initial shock, with economies failing to find new import and export markets inside their own geopolitical domain. A flexible answer dramatically cuts the price rise from 5% to 1%.

So, will everything return to normal soon? Not so quickly. Other global forces are at work as well. One example is demographics. Global population aging is anticipated to diminish labor supply while increasing employees’ negotiating power, implying that increased inflation may lead to wage-price spirals. The expense of the green transition, with massive investments in new technologies and the abolition of old ones, produces a demand-supply mismatch that is expected to raise costs.

In the absence of a cataclysmic supply shock like a Chinese invasion of Taiwan, these structural dynamics are likely to be more relevant than the possibility of geopolitical fracturing and harm to the global goods trading system. How such price level shocks affect medium-term inflation is determined by the reactions of central banks, employees, and employers. Those who are worried about global tensions and trying to link them to the expense of living are usually searching in the wrong place.

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