On September 15, 1950, General Douglas MacArthur orchestrated a daring amphibious assault at Inchon, South Korea. This bold move resulted in a stunning victory for the United Nations forces, enabling them to recapture Seoul and push the North Koreans back above the 38th parallel. Following the assault on September 29th, General MacArthur confidently declared, “The war is very definitely coming to an end.” However, his optimism was short-lived as the Chinese People’s Volunteer Army intervened in November, launching a massive counteroffensive that drove UN forces back south of the 38th parallel. The conflict would persist for another two and a half years, with neither side achieving a decisive victory.
Today, it appears that economists, analysts, and politicians are all displaying MacArthur’s overconfidence in their belief that they have won the war against inflation. This overconfidence is so overwhelming that they are already hinting at a pivot by the US Federal Reserve and European Central Bank towards stimulating employment and economic growth by lowering interest rates. While I do believe that the Fed will lower rates due to economic weakness in the near term, I question if we have truly emerged victorious in the battle against inflation in the medium and long term. My apprehension is that we may be witnessing a MacArthur moment unfolding in real time.
The foundation for the reversal in global inflation trends was laid in 2008 and ignited in 2020 with the onset of COVID, only to be exacerbated by the Ukraine war in 2022. The major shifts outlined below form the basis of my argument for structurally higher inflation in the future:
- Technology. Generally, technological advancements tend to be disinflationary. While AI is expected to enhance productivity over time, questions remain about the timing of its impact. In the near term, the rapid ascent of AI necessitates a significant expansion in the infrastructure of microchips, data centers, power generation, and electricity distribution. This will continue to put upward pressure on commodities and electrical pricing. And of course, with such a massive investment, will AI be as strong of a deflationary force as the internet, email and smart phones were?
- Green Energy. Over the past decade, we’ve witnessed a massive influx of investment into alternative energy, which is finally starting to rival fossil fuels in terms of energy production. It’s difficult to imagine any country that has invested so heavily in this transition suddenly deciding to revert to a reliance on fossil fuels. Energy production, electricity distribution, and transport are all extremely capital-intensive sectors, so these investment programs will exert upward pressure on commodity prices and global aggregate demand. This will occur while simultaneously reducing global energy supply, at least for the lengthy transition period required to replace fossil fuels.
- War. It’s no secret that wars drive inflation, and the Cold War 2.0 is no exception. Countries around the world are ramping up their war industries, including traditionally neutral nations like Germany, Japan, and Sweden. The combination of rising defense expenditures and demographic pressures (see below) will likely result in extreme fiscal pressure.
- Demographics. Across the US, Europe, and Japan, the retirement of the baby boomers is putting a strain on government budgets as the demand for healthcare and retirement benefits continues to grow. This situation is inherently inflationary and is compounded by opposition to immigration, which means shrinking workforces and labor shortages that drive up wages.
- Government Debt. Government spending and persistent budget deficits could spur inflation in one of three ways: 1) Another crisis occurs where the government rides to the rescue and creates money (i.e. stimulus) to save the economy like 2008 and 2020. 2) Government spending may divert from productive endeavors to less productive endeavors such as health care, pensions, guns, missiles for military operations. 3) Increased debt issuances to cover ballooning deficit floods the banking system with more money that makes its way into the businesses and consumers. All three of these can be countered by a disciplined, tight Federal Reserve monetary policy.
- Deglobalization. Since China joined the World Trade Organization (WTO) in 2001, inflation has been kept in check, staying below 2% in the US and around the world. However, the COVID pandemic and escalating tensions with China have led many industries to reassess their investments in the Far East. While some supply chains are relocating to Vietnam, India, and Indonesia, others are finding new hubs in Central and South America. Additionally, the US and Europe are implementing protectionist policies (i.e. tariffs) specifically aimed at curbing Chinese competition.
Perhaps I’m off the mark in predicting that inflation will stick around for the foreseeable future. I genuinely hope I’m mistaken. History has shown us that inflation is hardly a one-time event but rather a long-term process of pain. And with the pressures outlined above, it’s tough to envision a scenario where inflation drops and remains at or below the 2% target. Many of these trends could play out over years, if not decades. Let’s keep our fingers crossed that our policymakers don’t repeat the same mistake General MacArthur made.
