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Editorial: A New Wave of Inflation

Chennai, 30 March 2022:

Federal Reserve Chairman Jerome Powell and his counterparts like European Central Bank board member Fabio Panetta have described inflation as “transitory” again and again, but that well-worn term is starting to sound almost as out of place as “fifteen days to slow the spread.” Maybe inflation is here to stay?

Nobody believes that prices will go back to the level they were at in 2020. That would require deflation, where the cost of goods and services trends down, not up. In that scenario, consumers delay purchases and save money because whatever they are planning on buying will be cheaper down the line. This puts pressure on businesses facing top-line revenue reductions, compelling them to cut their bottom-line costs to stay afloat.

That means negotiating lower prices with their suppliers, which perpetuates the same problem downstream. Or what is far more likely, businesses cut costs by firing workers and shutting down sites. The goal is to have stable, Goldilocks prices. This traditionally has been understood as prices rising two percent or less in a given year. The U.S.’s 10-year inflation average for the years 2011-2020 was 1.75 percent; for the Eurozone, 1.28 percent.

In other words, in Europe and America central banks have done a decent job. We’ve all gotten used to the idea that, from one year to the next, prices may go up a little, but there won’t be any sudden or surprising movements.

In India we are at crossroads. Even though RBI’s inflation projections have a wide range of possibilities, the consumer inflation expectations 1-year hence have been anchored at around 11% for the past year (unlike say in the US, where inflation expectations have consistently moved higher). Indian consumers believe that the rise in inflation is transitory.

However, geopolitical risks (Ukraine war risks higher food and fertilizer prices) as well investment demand (ESG, which would use up energy/metals to create a cleaner world) bodes higher inflation. It is likely that if supply side inflation continues, the inflationary expectations will eventually rise. RBI may need to be more assertive to control inflation – better perhaps to stomp out the smoke rather than fight a fire. The RBI’s action in the next few months remains critical in deciding the path of the Indian economy for years to come.

At least until now. Year-over-year inflation for 2021 hit five percent in the E.U. and seven percent in the U.S., shooting well past anything anyone regards as acceptable. Quarter by quarter, both economies racked up numbers not seen since the 1980s.

Word on the street is even more dire. Some older cars are selling for more than they cost when they were new. And dealerships are selling out of new stock as soon as it arrives, perhaps because the manufacturer’s suggested retail price for a new car is cheaper than buying a used one. Martin Weiss of Deutsche Automobil Treuhand (DAT) remarked: “The price increases are often five to 15 percent. In individual cases they can be significantly more. It’s crazy what we’re seeing.” And that’s another facet of inflation: If prices don’t move up fast enough to stay in line with the market, the result is a shortage. People snap up assets because they immediately feel the value.

This depletes the supply chain, which has trouble replenishing itself with new product because the cost of production has, in the meantime, gone beyond the revenue generated at the final point of sale. When this self-reinforcing price spiral becomes sufficiently powerful, it compels companies to increase prices faster and faster – quarterly or monthly, rather than once a year.

Take Hyundai Heavy Industries (HHI), South Korea’s largest shipyard, where newbuild prices are up 12 percent year-over-year. HHI was paying more for steel plate to fill its existing orders, so it suffered a loss. Steel plate makes up 90 percent of the material used in fabricating a typical commercial vessel. HHI’s situation – prices for its products are up but its bottom line is underwater – is what triggers the inflationary spiral.

Shipbuilding contracts are normally divided into four parts with specific triggers: a down payment due upon signing, a second installment due upon cutting the first steel plate, a third installment due upon keel-laying, and the remainder due upon launch. All of these installments add up to a single, total price for the newbuild, which is usually non-variable.

This model works in a low-inflation environment with stable costs. An owner could calculate a price, obtain financing and then, ideally, amortize the vessel via a long-term charter party after paying the shipyard. To avoid the situation HHI is in now, wherein it absorbs the shock from rising steel prices, it will need to contractually offload those price problems onto the owner.

Two possibilities are available. First, the price of the newbuild doesn’t need to be quantified up front; rather, it can move in line with the market and the owner will only know what his ship will cost after it finally launches. Typically, this construct is achieved by building price adjustment clauses into the shipbuilding contract requiring the owner to cover costlier materials or even higher labor costs and new taxes and fees.

Second, cost-plus contracts may come into vogue, which require the owner to reimburse the shipyard for all of the vessel’s building costs plus guarantee a fixed, predetermined margin of profit for the yard. Both of these contractual mechanisms protect against inflation but make life hard for the buyer.

Especially tricky is the fact that the owner will only be able to quote a charter party rate after the newbuild is launched since any risk in the commitments made to the shipyard will need, in turn, to be passed on to the charterer. Thus, the charterer will necessarily pass that risk on to the cargo side, i.e., to shippers, who will, spiral-style, ask consignees for more money. This is what is meant by “perpetuating the same problem downstream.”

Curtailing inflation through monetary policy is a lesser problem when there is demand driven inflation – as high growth led to such an inflation in the first place. In supply-driven inflation, the monetary policy impact can be high as the growth may not be robust to begin with. Imagine if the central banks hike the rates, and soon after, the supply shocks to inflation evaporate, the central banks’ actions would have led to fall in demand and growth, even though the inflation would have receded by itself.

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