Deep-seated trends in trade and demographics helped keep inflation in a comfort zone for decades, but both are now pushing in the opposite direction. Globalization was fraying even before pandemic and war made things worse. Growth in the world’s labor force has slowed.

Then there’s the looming cost of transition to net-zero carbon emissions — likely to push all kinds of prices higher in the years ahead -– and the prospect of a sustained run-up in rents due to America’s dearth of affordable housing.

Q1 2022 hedge fund letters, conferences and more

It all adds up to a changed landscape. Yes, inflation probably will retreat from near four-decade highs, as supply-chain snafus unwind and economic growth slows in response to interest-rate increases by the Federal Reserve. But it may prove stubbornly higher than the 1.5%-to-2% range that American consumers, businesses and investors grew accustomed to before the pandemic spike.

“The long era of low inflation, suppressed volatility, and easy financial conditions is ending,” said Mark Carney, who ran the central banks of Canada and the U.K. The economics of the coming period will be “more challenging,” he said.

In this new environment, borrowers from homebuyers to the US Treasury will have to pay more. There’ll be fewer jobs for workers, as the Fed puts a squeeze on labor markets — and more risks for investors, who’ll have to factor in a central bank more preoccupied with cooling inflation than promoting economic growth. Politicians may see more pushback against their spending plans, and they’ll face voters increasingly unhappy about rising costs of living.

‘Old Testament Mode’

Fed officials have hinted that they see lasting shifts ahead.

Chair Jerome Powell said last month that globalization has slowed down — and that if goes into reverse, “it would be a different world.” Richmond Fed chief Tom Barkin cited the potential for “more medium-term inflationary pressure” that the central bank will have to take into account as it strives to hit its 2% target.

Where inflation ultimately settles will largely depend on what the Fed -– and the American public –- are willing to tolerate.

The late Paul Volcker showed in the 1970s that the Fed has the tools to rein in inflation, but at a high cost. To break the back of double-digit price gains, he drove the economy into a deep recession and pushed unemployment above 10%.

“If you ask me where inflation is going to be in the next 10 years, I’m going to tell you it depends centrally on what the Fed’s preferences are,” said JPMorgan Chase & Co. chief economist Bruce Kasman. “And the Fed’s preferences have to do with societal preferences.”

Kasman reckons that Powell & Co. would be comfortable with inflation landing in a “sweet spot” around 2.5%.

Anything much higher, he said, would likely tip the Fed into “Old Testament mode.” Out would go the forgiving approach to missed inflation targets — to be replaced by “a vengeful central bank that starts to smite us.” In that scenario, recession risks would rise significantly.

Following are some of the long-run inflationary forces that the Fed will have to contend with:

(De)Globalization

Almost 20 years ago, at the Fed’s Jackson Hole symposium, Harvard University professor Kenneth Rogoff pointed out that the removal of trade barriers was helping to deliver lower inflation worldwide. Now Rogoff worries that’s going into reverse, under pressure from a hot war in Ukraine and a Cold War-style contest between the US and China.

It started with the tariffs President Donald Trump imposed on China. They added about a quarter of a percentage point to US inflation in 2018, analysts at the Peterson Institute for International Economics estimate.

Since then, both the pandemic and Russia’s invasion of its neighbor have accelerated efforts by governments and multinational firms to make their supplies –- whether personal protective equipment or microchips — more secure. Which likely means more costly.

That’s a big deal. Before last year’s pandemic-driven surge, US consumer prices for goods (not counting food and energy) were basically unchanged since China entered the World Trade Organization some 20 years earlier. What inflation there was largely came from services, where prices were rising at an annual rate of about 2.7% over the period.

If waning globalization means that goods prices are now set to rise by 1% to 2% a year, as Moody’s Analytics chief economist Mark Zandi expects, then service-price inflation will have to come down if the Fed wants to meet its 2% target. That might mean crunching a sector of the economy that employs the vast majority of American workers.

Read the full article here by Rich Miller, Advisor Perspectives.