“Happy families are all alike; every unhappy family is unhappy in its own way” (Tolstoy, 1875-1877/2001, p.1)
Not all inflationary shocks are the same, but the sustained inflationary shocks share a combination of an expanding monetary base with exogenous shocks. Can that shock come from climate related charges being considered in the costs of production?
There are questions regarding inflation that can only be answered over time. The fundamental question, is there actually inflation? Is the recent increase transitory? Are we entering a period of permanently higher inflation? What are the likely drivers of higher inflation?
What we do know is how to beat inflation. Higher interest rates achieve that, although exactly how much higher is not clear and is dependent on the type of the inflationary impulse.
US CPI and cash rates back to 1959 (Inflation is the Gold line).
The inflation surge of the late 60s was driven by expansionary fiscal spending on social programmes and the Vietnam War. The 70s surge in inflation was also driven by fiscal programmes with the substantial exogenous impact of the rise in oil prices.
The period from the mid-1960s until the early 1980s was inflationary; from the mid-1980s until today, CPI inflation has been tamed by interest rate increases when required. But monetary growth has been “off the charts” post COVID.
Can the repricing of inputs to reflect the true cost of production (primarily carbon) signal a new round of cost push inflation. If inflation is driven by a permanent change in the costing of all inputs, then the policy response will differ from a simple increase in interest rates.
“Effective carbon taxes and cap and trade schemes, such as the EU emissions trading scheme, force companies and consumers to pay a more representative cost for their activities and incentivise them to find the most efficient way to reduce emissions. Beyond carbon emissions, global solutions are needed to ensure polluting activity cannot arbitrage between jurisdictions.” (Luis de Guindos, Vice-President of the ECB November 2019)
There are two scenarios; first we move to a carbon pricing model that gradually increases the clearing price of carbon over time or more dangerously we fail to adapt the costing of inputs and therefore create the conditions for a climate catastrophe. Inflationary pressures arise from both but a decline in the national and international supply of commodities, or, from productivity shocks caused by weather-related events such as droughts, floods, storms and sea level rises is more problematic.
“The U.S. has sustained 291 weather and climate disasters since 1980 where overall damages/costs reached or exceeded $1 billion (including CPI adjustment to 2021). The total cost of these 291 events exceeds $1.900 trillion.
The 1980–2020 annual average is 7.1 events (CPI-adjusted); the annual average for the most recent 5 years (2016–2020) is 16.2 events (CPI-adjusted).”
As always with climate, there is an urgency that may force the payment of green premiums if timely technology to reduce carbon does not emerge.
“The longer the implementation of these policies and the transition to a low-carbon economy are delayed, the sharper the future reduction in carbon emission to meet the climate goal will need to be, and the higher the transition risks”. (Mark Carney, 2018)
Yet, many see a carbon tax as having only a transitory increase on the inflation rate, as would the implementation or change in VAT/GST.
Will technology emerge to eliminate the “green premium” as we move towards net zero emissions? If technology doesn’t develop in the timeline expressed in the 2016 Accord, how much of the move to net zero will need to be funded by the payment of green premiums to meet emissions targets?
Then, add the increased regulatory costs of ESG reporting as it is introduced.
“The PRI’s US signatories are aligned and their message is clear: The SEC needs to establish a comprehensive, mandatory climate and ESG disclosure regulation that puts decision-useful information in one form and place, and ensures that information is accurate. Anything less would perpetuate a system that misallocates capital and leaves unmanaged investment risk for savers and retirees across the country.” (Source: https://www.unpri.org/pri-blog/us-pri-signatories-support-mandatory-climate-and-esg-disclosure/7849.article)
Who will pay for these increased costs?
The growth in debt for the private and public sectors has been a dominant macroeconomic factor in GDP and asset market appreciation since 2000.
Fundamental to the increase in levels of debt has been the ability of both public and private borrowers to service that debt, driven in no small part by lower inflation and therefore lower interest rates. How will different climate policies impact a country or company’s ability to issue new debt? Sustainable bond issuance is growing rapidly but remains a fraction of the global bond market.
Governments will constantly be weighing up the pace of regulatory change with the impact on GDP, employment and ultimately inflation. A recent report by the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), suggested a carbon price of $160 a tonne would be needed by the end of the decade.
"Long‑term interest rates tend to increase in the transition scenarios, reflecting the inflationary pressure created by carbon prices, as well as the increased investment demand that the transition spurs on."
World leaders will head to Glasgow in November for United Nations talks to map a smooth path into 2050, their decisions may impact more than just emissions.
There are a lot of moving parts.
Inflation is back in play but the impact and dynamics of transitory recent increases remain unknown. What we see now is money supply growth combining with both increased Government expenditure and the base impact of COVID. Perhaps this will not be enough for inflation to remain sticky. Interest rate increases have always proved to be effective in combating inflation, but exogenous inflationary shocks can exacerbate the size of the rate rise needed.
There is significant inflationary risk in a move towards a true costs of production model as well as significant uncertainty. If we go down this path it would represent one of the most significant changes in product costing in history. The move towards that seems irreversible but the pace of change remains an unknown.
The Federal Reserve has just announced their new policy projections, targeting rate hikes in 2023? Is this really new news or just the Fed up to its old games of projecting inflation targeting success? As the chart of US CPI implies, inflation targeting has been a successful Central Bank strategy in controlling inflation but has been unsuccessful in trying to fuel sustainable price increases. (US CPI 1970 – today)
David 'Bushy' Nolan
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