The yes and no of inflation revival — how far downstream are you?


Once upon a time, there was this epidemic that people were suffering from all over the world. People called it “inflation.” Three causes were determined for its emergence. One was demand-pull. This happened when too many people were wanting too much of everything at the same time. The other was cost-push. This happened when everything was costing everyone too much. The third cause of the ailment was excess liquidity. This was when your central bank was printing too many notes too quickly.

By the final decade of the 20th century, people started believing the human race had triumphed over this particular disease. It became fashionable to proclaim the death of inflation. A few years into the 21st century, however, it is beginning to look as though the menace is coming back. Or is it?

You would expect a typical economist’s non-answer to be “Yes. And No.” And you would be right. Yet, for once, this actually may not be quite such a non-answer.

To the extent that international commodity prices are rising rapidly, metal exchanges are seeing increasing jumps in price indices, and steel producers are asking for higher prices from customers, the answer is clearly yes. All of this is due to soaring Chinese demand. Demand-pull inflation is very much alive and kicking where China’s appetite for staple goods is concerned.

A quite different vista opens up, however, when one looks farther down the supply chain at household electronics, processed foods, and wining and dining establishments. In the world of consumer goods and services, demand-pull has little inflationary effect, because however much demand may pull, there will always be newcomers on the supply side willing to offer ever more competitive prices. Such is the rule in today’s highly globalized markets.

Cost-push inflation, as we have historically known it, is also much less easily caused today than back in the old days. Offshoring, that anathema of U.S. trade unions, ensures that this is so. Even the presence of excess liquidity in an economy does not guarantee the manifestation of inflationary trends, since excess liquidity in one economy can quite easily be invested elsewhere via the global financial market. Even the most conservative Japanese investor will tend to own a non-yen-denominated account or two these days.

Thus, the precise answer to the question of whether inflation is back is indeed “yes and no.” It is yes, if you are looking at raw materials and basic supplies for manufacturing. But it becomes increasingly no, the farther downstream you go in the supply chain.

This is a tough state of affairs for the downstream inhabitants. They are caught between a rock and a hard place. Just lately, Japanese producers of tofu and soy sauce, both critical elements in the standard Japanese diet, have started to raise their wholesale prices because production costs are rising. Restaurateurs and supermarket managers have no alternative but to pay the higher prices. But they would have to be in a suicidal state of mind to pass these higher cost burdens onto their customers. They will just have to cut their profit margins. And only those who can endure the margin squeeze will survive. Those who cannot will just have to fall by the wayside.

So today’s reality is that inflation at the upstream end of the supply chain is actually begetting deflation in the downstream regions. This self-perpetuating cycle of deflation grows worse at the tail end of the supply chain, for the very same reason that inflation is returning to its starting point. The new epidemic is thus a twin-headed monster.