Moderate inflation and runaway inflation

MODERATE inflation is inflation that exceeds garden-variety; ordinarily it denotes 20-25% annual CPI. The usual thinking is that old school ‘moderate inflation’ either steps back to garden variety or quickly turns into ‘runaway inflation’. Now, runaway inflation is just another name for hyperinflation, but here I use the term to emphasize that 20-30% inflation is neither high nor chronic nor does it comfortably provide a persistent plateau. It will either fall to single-digits or jump to a higher plateau, and if this happens we will be back to the 1990s in a sense. Could this happen? As domestic producer prices are now a clear and present danger, and the risk of a 50% D -PPI is very real, could then CPI also rise to a much higher plateau?

WHERE DO WE STAND?

Annual CPI now stands at 17.53% whereas annual D -PPI is at 43.22%. There is a large gap. Producer prices reflect costs, and therefore they go up fast as the exchange rate depreciates. What we call the exchange rate pass-through effect isn’t only the direct impact of the exchange rate it also includes imported intermediate goods price changes. Import prices, including energy prices, add to the direct impact. The rather fast-moving multiple at which such a translation occurs is dependent on both oil prices and the exchange rate. I can add to this a ‘residual’, which one might call inflation memory and/or pricing behavior parameter. To the extent economic actors believe that they face a prolonged period of high inflation or an extended time frame during which the lira might not stabilize, they will try to pass on production cost increases to consumer prices faster and at a higher rate.

Although the c. 43% PPI-18% CPI gap won’t automatically close such that CPI rises very steeply to catch up with the PPI, this time around there is “accumulated inflation” that awaits us in H2 2021. Even if the lira stabilizes, as it stands, the already incurred production cost burden will show in the CPI in the coming months. 20-25% peak CPI is now in the cards regardless of lira stabilization. Of course, this is according to the official print. People’s perception of inflation stands higher.

There are two factors that might help curtail CPI hikes. First, domestic demand could so swiftly collapse that producers would be unable to reflect cost pressures to retail prices, in which case they will produce for turnover alone, and not even EBITDAs will be secure. Second, the lira not only stabilizes but it actually gains value. Furthermore there can be a clear and credible new programmatic approach such that economic actors believe there is a sea-change. Otherwise, I would expect to see over 20% CPI shortly, and even after the peak ‘official’ inflation is behind at some point, 18% year-end CPI is likely. Moreover, moderate inflations tend to move either way, up or down.

WHAT CAN HAPPEN?

Inflation is likely to hover around 18% although its trend is a bit less. It can remain in the high single-digit zone, but again there is likelihood it jumps over 20% anew, and that isn’t conditional upon a currency shock. Even without a shock that can well happen. Furthermore, there is a distinct possibility of “overshooting ” the target for many years to come, if indeed there is any ‘inflation target’ as we understand it. Obviously, the exchange rate played a big role there. But how could it have been otherwise? After all, that the exchange rate used to be the most effective nominal anchor in the last decade is fairly clear. This is what explains the existence and centrality of the “crawling peg ” in the 2000 program. Inflation could not have been reduced to low levels in the absence of an explicit or implicit nominal anchor and this is what happened 18-19 years ago.

We know theoretically that should an exchange rate argument be explicitly recognized in the Taylor Rule the resulting dynamics would be qualitatively similar to that of a pegged exchange rate regime. However, this is not the end of the story. Just as inflation fell in 2004 to single-digit ‘garden variety’ as a result of a vector of factors, so it rises now not because of a single variable. Domestic demand was weak at that time and, for other than necessary goods, food and suchlike, it became more price and income-elastic after the 2001 crisis. That affected pricing behavior, drove profit margins down, mark-ups tended to fade and pricing power was lost. Firms were forced to experience a “learning process”. Now it is exactly the reverse. Although input prices fell, final prices didn’t. Inflation clearly contributed to profits because ‘super-profits’ are in the pricing now. From the political economics standpoint, this is a process of reconstructing, reshaping of market and political powers, redistribution of assets and income and politically structural change.

INFLATION ACCOMMODATION AND LONG-MEMORY FORMATION

The question is: what to do with all this? If you accommodate inflation, what you have to do is simple. Print money if need be, and

raise wages accordingly. Now, 22-25% wage increases aren’t something Turkish businesses can handle at this point. The state can do that, but if it does it will accommodate inflation. And, obviously, it is not doing that currently. Well, if you don’t do that obviously real wages will erode fast – because inflation is in effect, a tax and people will feel that right on the spot. But if you do that, you will index inflation. Now, backward indexation creates or at least adds momentum to the inflation memory, and renders it persistent.

The tricky thing here is to determine whether inflation is here to stay or is it a one-off event. Obviously, it isn’t a one-off event, which leaves little choice. The choice is the optimal level of wage adjustments. Perhaps forward-indexation is a good idea. This way as credibility builds up anew and inflation expectations fall, wage adjustment multiples would also fall. Anyway, wages are in general pro-cyclical in this country and inflation never builds up because of wage increases. Except the pivotal minimum wage that creates a zone of a-cyclicality across the business cycle, wages haven’t been a cause for concern over almost three decades.

This is not Argentina. No, there hasn’t been an excess demand that has kept inflation always high either. Inflation at its very heart is a cost phenomenon; therefore, an exchange rate phenomenon. Imported intermediate goods matter and FX debt matters. Material balances’ costs and financing costs drive producers’ prices. Consumer prices follow not because there is always excess demand at the margin – lack of market-clearing at infinity, which is a theoretical possibility - but to the extent demand is strong enough to allow producers to reflect costs on to retail prices. The rest requires a symptom-laden reading, what inflation in reality stands for, its relationship with the current account deficit and suchlike.

CAPITAL AND DEBT

In my opinion we aren’t directly looking at an investment cycle, but rather at a debt cycle globally. Capitalism today looks more like credit (debt) than ever; not capital. Not only Turkish firms balance sheets and banks’ hidden NPL stocks risk being wiped away but even the developed corporate world is sitting on a time bomb. If the IMF’s risk assessment is anywhere near the truth, close to half of the developed world’s firms carry serious risks. There is not only a corporate debt overhang, so to speak, but also risky firms are becoming more and more indebted because their EBITDAs are too low. Debt looks riskier than ever.

Not only is debt-to-EBITDA rising, but also EBITDA-to-debt service (interest) is dropping. The risk went up to 40-45% of outstanding bond stock in the developed world. At that point, one should perhaps ask: By what metric? Truly, the value-atrisk here is rather a tail risk, which assumes a Lehman-like shock. Traditional risk metrics may not work because credit still carries near-zero rates. The whole credit surface has been spatially translated from one risk coordinate system to another, just like in 2017 with the advent of the Credit Guarantee Fund. Firms that wouldn’t ordinarily get access to credit because they couldn’t create sufficient funds to pay even their extant debt got more indebted because even a slightly positive interest-carrying bond looked attractive in that twisted financial world.