Global inflation: Can it be tamed to 2%?

Global markets are pricing in inflation of about 2.5% two years from today.  This reflects either wishful thinking or a naïve belief that central bankers have the issue under control and will deliver on their promise to get inflation back to 2%.  

This is the view of Alec Cutler, portfolio manager at Allan Gray’s offshore investment partner Orbis, who says that there are new inflationary impulses that are not being added to the prediction.  

“The ESG wave is driving a new inflationary impulse that is gaining steam and doesn’t look to be reversible. This is ‘greenflation’, and while it is completely new, we expect it to have a significant impact on inflation going forward,” says Cutler.  

He explains that the War on Carbon is forcing economies to decarbonise. Most frequently, this translates into electrifying.  

“Economy wide, this will require a gargantuan amount of capital spending on capacity over the coming decades that may for the first time in history drive lower productivity for the investment outlay,” he says.  

And alternative energy and its electricity output are not getting cheaper every year, given that all the input prices for what’s needed to make solar panels and windmills have skyrocketed, owing to the drive for electrification.  Leading wind turbine maker Vestas, for example, has seen a 65% drop in its share price from the start of 2021, because input prices have skyrocketed.  

Cutler explains that shifting from the most efficient energy source to the greenest energy source adds to the cost of the products produced, because not only will the producer have to amortise the cost of capital it took to build the required new plant or process across all units produced, but also because the cost of making each unit is higher.  This is happening at all levels of the supply chain.  

“Think about the added expense of building roads from an alternative material to tarmac, a cheap residual from the oil refining process, or about the massive investment required to reorient and recable electricity transmission systems.  Electrification and elimination of carbon-based inputs are greenflationary.”

He says that alternatively, and increasingly where we’re heading now, is to admit that we need to continue to burn fossil fuels, but force operators to capture the carbon from the process and store it away forever, a process called Carbon Capture and Sequestration (CCS).

“This makes a lot more sense than trying to electrify.  Examples would be natural gas or biomass power generators, refineries, and chemical plants.  Here, carbon collection processes and takeaway infrastructure can be added to existing plants.  But again, this is the definition of inflationary.”

Orbis estimates that biomass power generator Drax, who is taking the lead in installing CCS, will need to use 15% of their current electricity generation capacity to power the decarbonisation process.  

“This may be a net win for society, but we can’t get around the inflationary impact it will have.  Carbon capture is greenflationary.”

Cutler says there are several levers that all represent fairly easy to see swings of the pendulum that helped reduce inflation for the past 10-40 years, but all seem to be reversing direction at the same time.

“If 2% is supposedly the inflation produced by a normal healthy economy, shouldn’t we consider laying on the inflationary impulses coming from reshoring a big chunk of the productive parts of our economy and the impact of the reversal of a 40-year pendulum swing away from labour power? And how will the necessary reversal of Trump’s big corporate tax cut and his war on regulation impact inflation?” questions Cutler, concluding that we really don’t need exact answers to have decent conviction that expectations for 2% inflation are likely to be disappointed, absent some massive new deflationary impulse counterweight.

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