High Inflation, Temporary or Permanent?
As long as the government is able to realize its commitment to an open economy, I am sure that inflation expectations of economic players in Indonesia will fall and be low.
Almost everyone agrees that current inflation is caused more by factors from the supply side than from the demand side.
The most-debated issue at the end of 2021, when accelerated price increases started to occur, was whether the increase in the inflation rate would be temporary or permanent.
Several major economists, such as Professor Paul Krugman in several of his columns in the New York Times, were initially in the same camp as the United States central bank, the Federal Reserve, which considered that the inflation was temporary.
Thus, the Fed did not need to raise interest rates because an increase in interest rates could cause greater harm than benefit.
On the other side, Professor Larry Summers (2022), former US treasury secretary under former president Bill Clinton and chairman of former president Barack Obama's Team of Economic Advisers, considered the inflation to be permanent.
The Fed did not need to raise interest rates because an increase in interest rates could cause greater harm than benefit.
Summers urged the Fed to immediately raise interest rates so that the long-term inflation balance point would not too high and the adjustment process towards this balance would not take too long nor be too burdensome for the public.
While the Nobel laureate in economics, Professor Michael Spence (2022) and Professor Nouriel Roubini (2022) in the latest book Megathreats argued that the recent surge in inflation was more secular in nature (permanent) and would last in the long term, more fundamental and structural factors spurred the acceleration in global price increases.
Both of them reminded decisionmakers, including those at the central bank, that the policy responses that should be made would be different if the inflation were temporary.
Fundamental factors
What are the fundamental factors that can increase and reduce the risk of increasing long-term inflation in the future?
On the positive side, we see that technology, especially digitization, will continue to reduce prices and price fluctuations, both for manufactured goods and food and agricultural goods. Digitalization will reduce transaction costs and various uncertainties and allow companies to minimize inventory costs and be able to make more appropriate decisions.
However, both Spence and Roubini point to a number of factors that are more dominant in driving long-term inflation. For several decades, the price of manufactured goods has declined as a result of the expansion of the manufacturing industry in China and several other emerging market (EM) countries that have taken advantage of cheap labor wages.
Globalization, which has reduced global inflation since the early 1980s, has also been made possible by persistent declines in transportation and telecommunications costs.
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This trend has stopped and the tendency will be reversed due to several reasons. First, the demographic transition in China, partly due to the one child policy and an aging population structure, resulted in a reduction in the supply of additional labor in China and spurred a significant increase in wages.
Wages in China have increased six-fold in the last seven years. This increase in wages resulted in a persistent increase in the price of manufactured goods in China. Some manufacturing industries deal with this increase in wages by moving their factories to other countries where wages are still low. Some do automation using robots.
This response as a whole will still not bring the prices of manufactured goods back to their former level. Changes in the aging population structure do not only occur in China, but have occurred in developed countries, such as Japan, the US and Europe.
Even in a number of EM countries, this demographic transition has almost attained its peak and will soon reach a stage where the percentage of the productive population to the total population has decreased. The demographic transitions will all lead to increases in wages and costs, which in turn will raise the general price levels.
Second, migration to developed countries, which previously filled labor shortages, is also experiencing obstacles due to increased anti-migrant sentiment in developed countries. This factor also causes wages to increase.
The third factor is related to the symptoms of deglobalization, protectionism and inward-looking policies aimed at protecting workers in local companies, which are detrimental to the economy. The price of imported goods will increase, the increase in total factory productivity will slow down, production costs will increase and this in turn will have a detrimental effect on economic growth.
Fourth, reshoring (relocation of manufacturing industries to countries of origin) may secure supply chains, but moving production centers from low-cost emerging economies such as China to "friendly countries" will cause costs and prices to increase, as well as price fluctuations.
The US and China's intensive competition has also turned into a trade war. Trade wars followed by trade restrictions and two-way tariffs will also be followed by restrictions on technology, investment, data and information. The expansion of restrictions will cause the cost of productivity development to rise and in turn will increase prices and price fluctuations (inflation).
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Geopolitical shocks stemming from the cold war between China and its effective allies, such as Russia, Iran and North Korea, with Western countries will push prices up. Russia's invasion of Ukraine has increased energy and food prices and world inflation.
This escalation of geopolitical issues can occur with the emergence of new sources of tension, such as between China and Taiwan (encouraging US interference); Iran-Israel and other Middle Eastern countries; and North Korea versus South Korea and Japan (again encouraging US interference).
All of this will increase the uncertainty of most of the countries involved in potential conflicts, which are the world's manufacturing hubs, world food producers and/or world energy sources. As a result, prices tend to rise, as well as fluctuations.
Global climate change trends also have the potential to increase prices and price fluctuations in a number of ways.
First, climate uncertainty will threaten agricultural and livestock production. Drought has hit several parts of the world, such as North Africa and parts of the US. As a result, there will be spikes in food prices and price fluctuations are expected to increase in frequency in the future.
Second, the trend toward decarbonization will lead to underinvestment in fossil-extraction activities, without being followed by a sufficient increase in the supply of green energy. Energy prices will increase and fluctuate, as long as this uncertainty continues. Steps to cover this gap in the next 10 years are not easy to realize.
Third, natural disasters that are becoming more frequent in all parts of the world will interrupt the supply and production of vital goods. Many factories are forced to stop production when extreme weather, such as floods, forest fires and droughts, occur.
Global pandemics, such as COVID-19, are expected to occur more frequently and the impact cannot be predicted. Human life being close to animals that carry pathogens (because animal ecosystems are damaged by climate change), permafrost melting in Siberia and breeding grounds for bacteria and viruses can cause pandemics to become routine.
The supply chain will depend on healthy persons who provide goods and services. Any disturbance that occurs (slowdown/breakdown) will damage the production stage, especially when inventory depends on processes that are just-in-time. Like during a pandemic, many countries tend to stop exports and try to achieve self-sufficiency in pharmaceutical, food and agricultural goods, even though they have to be paid a very high price.
Income and wealth disparities have pushed the regulatory or legislative pendulum towards pro-labor, pro-wage or pro-union and fiscal policies that can "kick back" such as what happened in the 1970s.
The fiscal-stimulus policy aimed at protecting workers and the unemployed will accelerate wage increases, which in turn will have an impact on rising inflation in the form of a wage-price spiral.
Many countries tend to stop exports and try to achieve self-sufficiency in pharmaceutical, food and agricultural goods, even though they have to be paid a very high price.
An increase in the frequency of cyberattacks will also disrupt the supply chain. Vital infrastructure, such as the power grid, will affect the security of electricity and energy supply as well as financial infrastructure. Investing in cybersecurity will require large amounts of funds and increase production costs.
Weaponization of the US dollar, which is used to punish opposing countries, such as those launched against Russia following the invasion of Ukraine, will reduce the role of the US dollar as the main global currency, both as a medium of exchange and foreign exchange reserves for the central banks of countries in the world.
The use of alternative currencies will temporarily cause fragmentation and disruption in global trade and investment (AMRO, 2019). This disruption creates uncertainty, which in turn will increase prices and price fluctuations (inflation).
Implications on Indonesia
Will the trend of increasing global inflation be the same for Indonesia? Indonesia is different from conditions in developed countries or China in several ways. First, Indonesia will enjoy a demographic dividend period until 2036. The aging population will occur gradually in several provinces.
In 2045 the percentage of the elderly population will only be 15 percent. This picture allows the impact of the wage-price spiral on inflation to be avoided in the next few years.
Second, Indonesia's neutral position allows Indonesia to "friend share" (various friends) on both sides so that economic capacity expansion can still occur.
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Third, the infrastructure development that has been carried out in the last 10 years has allowed interregional interconnections to run more smoothly and has allowed transportation costs to decrease.
This reduction in transportation costs can last longer if improvements in tariff management in infrastructure, such as ports and warehouses, can be realized so as to reduce logistics costs.
Fourth, as long as Indonesia does not implement protectionist and inward-looking policies in trade and investment, total productivity growth will be accelerated through the application of the latest and newest technologies.
These four factors are expected to be able to compensate for the effects of climate change, which is almost certain to be experienced by Indonesia.
As long as the government is able to realize its commitment to an open economy, I am sure that inflation expectations of economic players in Indonesia will fall and be low. Thus, Indonesia's long-term inflation rate can still be maintained at 2-4 percent for the next 10 years.
Mohamad Ikhsan
Mohamad Ikhsan, professor at the School of Economics and Business, the University of Indonesia
This article was translated by Hendarsyah Tarmizi
