Inflation causes economic disruptions and war—trade weaponization and great-power re-organization mean it escalates

Higher wages translate into higher costs for companies which, in turn, leads them to raise prices further as they attempt to remain profitable or at least break even. Wages make up more than half of total costs in the hospitality, food service and retail sectors where profit margins are already low. It is the job of central banks to halt such a wage-price spiral before it gets out of hand.

Raising interest rates is their main tool to do so, which is why Jay Powell, the US Federal Reserve chairman, promises to ‘keep at it’ until inflation comes down to the US target of 2 per cent on the Fed’s preferred measure of inflation, the core Personal Consumption Expenditure, which rose by 4.6 per cent in August. This could mean much higher interest rates will be needed, both in the US and elsewhere.

A new era of economic fragmentation

The Russian invasion has dramatically changed the geopolitical backdrop. We may be entering a new era of economic fragmentation, reversing four decades of globalization that brought lower production costs for businesses from off-shoring, lower prices for consumers from cheaper imported goods and higher incomes in many developing countries from new jobs in manufacturing goods for export, with China a key player. All of these effects kept a lid on prices through global competition.

Now the debate about temporary versus long-lasting inflation must reflect the weaponizing of trade and finance to disrupt past patterns of production and exchange.

The political rift between the US and China that developed under the Trump administration resulted in trade tariffs and restrictions on cross-border sales of semi-conductors and other high-tech equipment. The rift deepened under President Biden with bans on US companies to prevent them selling chips to China and the threat of delisting Chinese companies from the US stock market.

Then the invasion of Ukraine brought a raft of economic sanctions against Russia including freezing the foreign exchange reserves of its central bank and the assets of some Russian companies and individuals.

We may be in the foothills of an economic war between the great powers. The deeper ‘no-limits friendship’ proclaimed by Vladimir Putin and Xi Jinping presents a potent threat to an integrated world economy. Despite their chequered history, Russia and China perceive a common enemy in the West and share a resentment of being treated without the respect they feel they deserve.

China and Russia’s weak economic models

There is also a natural complementarity in their two economies. Russia has the energy and natural resources that China needs; while China has the technology and industrial know-how Russia lacks. Trade between the two has jumped with increased Russian oil exports to China, partly offsetting Russia’s loss of European markets due to sanctions. The two have also agreed to use their domestic currencies to pay for trade, rather than the dollar.

In addition, they are both autocratic regimes capable of controlling their domestic narratives and suppressing dissent. This provides a powerful base for propaganda and paranoia that can lead to irrational policy and a tit-for-tat escalation of disputes.

A chaotic period of economic disruptions and resulting inflation spikes is not certain. Both Russia and China have weaknesses in their economic models.

The Russian state is heavily dependent on energy exports which themselves are vulnerable to curtailed western demand, to the lack of western equipment and expertise and to the accelerated investment by others in renewable energy alternatives. China’s long period of rapid economic growth is staggering to a halt from its zero-tolerance policy towards Covid, while there is no sign of an exit strategy.

Meanwhile the property sector is in free fall and the many foreign enterprises that set up manufacturing in China, bringing skills and technology as well as money, have begun to relocate to India, Vietnam, Singapore and other more predictable business environments. Both countries suffer from shrinking labour forces and growing numbers of retirees needing healthcare and income support.

The incompatible reordering of global alliances

The West too faces challenges, including destabilizing threats to its democracies from populist political parties. The relative predictability of the post-Second World War era has been shaken by the global pandemic, geopolitical incursions and extreme climate events.

Instead of cooperative attempts to tackle such issues, they have led to a re-ordering of global alliances with incompatible narratives and increasing barriers and sanctions. This changing international environment means that the debate about inflation – its causes and possible persistence – is no longer just about economics and central banking. It reflects the complexity of today’s interconnected world and the tectonic shifts in great power rivalry.