All Things Point to One Way for Inflation: Up, Says Richard Koo

Richard Koo, Chief Economist at Nomura Research Institute, discussed the inflationary threats from rising energy costs, supply chain disruptions and higher-than-usual demand in his keynote address at Nomura Investment Forum Asia 2022.

Energy-fueled inflation

The sharp increase in oil, gas and coal prices began around spring 2021, long before the Russia-Ukraine conflict. While the immediate trigger was the economic recovery after the Covid-19 lockdowns, the increases have exceeded what would be expected under normal circumstances.

That’s because we have a new game in town and that is climate change. Starting from last year, governments around the world have responded to the growing demand for measures to mitigate climate change by implementing laws banning sales of new gasoline and diesel cars by early-middle of the next decade. As a result, energy producers, who previously operated under the assumption of consistent demand for fossil fuels, have become cautious to invest in new fossil fuel supply as they have limited time to recover investment costs and make a profit. Consequently, supply has been extremely slow in responding to the recovery in demand, leading to steep energy price increases.

Surging fossil fuel prices is one of the key reasons behind the current inflationary environment. In a sense, these higher prices are necessary to make fossil fuels less competitive and accelerate the switch to renewable energy. The shift to renewables could also see some countries impose higher tariffs on products from emerging economies that are not doing enough to fight climate change. This could lead to a slowdown in globalization and also be inflationary. Concurrently, we also face a long-term inflationary threat and disruption from a decades-long transition to replace equipment running on fossil fuels.

Supply and demand-driven inflation

Another source of inflationary pressure is demand. During the pandemic, inventory levels dropped sharply in the US as many retailers chose not to replenish their stock amid uncertainty about when customers would return. With vaccinations and the subsequent recovery of many developed economies, retailers are now increasing orders to build up inventory and meet potential pent-up demand as more customers come out of lockdowns. This is compounded by supply disruptions which have contributed to unusual demand.

The supply situation is problematic in a globalized supply chain. Covid-19 has affected countries unevenly, with supply disruptions in different regions at different times. The result is that companies are unable to get all the outsourced components they need to finish a product, making planning difficult. This unevenness and uncertainty in the global supply chain means that supply of the finished product is significantly lower than usual, again adding to inflationary pressures.

The US problem

In the years leading up to the pandemic, inflation was low in the US, reflecting low borrowing numbers despite the massive liquidity provided by the central bank. At the onset of the pandemic, we saw a sudden increase in borrowings in the US as people wanted to make sure that they had enough cash to make payments. That was short-lived as initial concerns about the pandemic subsided and borrowers started returning money to the banks.

What we are seeing recently are signs of demand-driven inflation. Starting from the fourth quarter of 2021, there was a sharp double-digit rise in borrowings by US companies and households, suggesting that borrowers are starting to return to the market for the first time in 14 years. Since banks have a massive $3.6 trillion in reserves, around 2,000 times greater than those before the Lehman Brothers crisis, it could fuel inflation and spell problems for the Fed. On top of this, there is the asset price problem with runaway prices for houses and commercial real estate. To stop inflation, the Fed must take action to simultaneously bring down the massive reserves in the banking system and raise interest rates. It is the greatest challenge the Fed has faced in a long time.

To watch the full presentation, visit the Nomura Forum website (requires guest login).