The inflation monster nobody saw coming

And why Wright's Law is not the best basis for green transition forecasts

Remember how important it was to jumpstart the economy — any economy — after the first wave of coronavirus infections? Remember how any news of a reversal in GDP figures that fell into negative territory was celebrated by analysts, economists, and news anchors? Now, the time has come for the inflation warnings.

One could reasonably argue that hindsight is a valuable tool for analysing past events that is, alas, not available to those experiencing said events. Yet given the fact that economic growth — and contraction — follows a clear pattern, it was a safe bet to make that with the restart of economies, with the generous fiscal support central banks provided, inflation would go up, that is, everything will become more expensive.

Oil is an obvious case in point. During the initial shock from the pandemic, oil demand slumped heavily. Then, the moment economic outlooks began to show signs of optimism, demand began recovering and previously doomsday forecasts are being hastily revised to reflect this reality.

The prices of copper, steel, lithium, cobalt, and nickel are also rising, in part because of rebounding demand for everything, and in part because of supply chain disruptions caused by the pandemic. Higher shipping costs, soaring because of those same supply chain disruptions, in some cases by over 100%, are also a problem.

Earlier this year Reuters reported that surging costs of transport, labour, and raw materials are prompting delays in new solar projects. The price of steel, the report said, citing analysts and industry insiders, had tripled recently, and the price of polysilicone had also increased considerably. This, the report said, was threatening the solar boom everyone forecast precisely based on lower prices, higher demand and Wright’s Law.

The law, often invoked with regard to EV prices, too, is an interesting one. Formulated by aeronautical engineer T. P. Wright in the 1930s, the law basically lays out the min benefits of a learning curve: the more we produce of something and the longer we do it (learning more about it in the process), the cheaper it becomes to produce.

On the face of it, the law should hold true for any industry. In reality, it is far from universal as we have currently given the opportunity to see. Across oil, solar panels and EV batteries, prices are soaring despite increasingly lower production costs for crude oil and increasingly advanced production technology for solar panels and EV batteries. The reason: tight supply.

Supply and demand would always trump learning curves and their benefits as the latest news from the oil, solar and EV fronts suggest. Supply chain disruptions are threatening solar power capacity growth, Reuters reported in June. Raw material shortages are raising production costs for cars to the highest in ten years, Bank of America calculated in a late-June report. Last week, the Wall Street Journal suggested that EV batteries will be the next victims of the supply crunch, price-wise.

Bad as this may be, it should be only a temporary snag, shouldn’t it? A sharp surge in demand for a product and a sharp tightening of supply are usually short-lived phenomena, quickly remedied by producers’ response in the form of production expansion. Yet not all agree that this particular raw materials shortage will be short-lived. Credit Suisse, for instance, has in fact predicted that lithium could be caught in a permanent shortage, with prices rising continuously over the long term.

It seems lithium is not the only one. The semiconductor shortage could extend into 2023, says the CEO of Intel as well as the vice president of research firm Forrester. And according to a recent WSJ report citing economists and business executives, the raw material supply crunch plaguing virtually every industry from mining to consumer products may extend into next year. The article quoted Fed’s chairman Jerome Powell as saying “It turns out it’s a heck of a lot easier to create demand than it is to—you know, to bring supply back up to snuff.”

Indeed, this appears to be the case for many industries, which explains the crunch extension predictions. On the flip side, the problem is certainly solvable, although perhaps not in the best possible way. CNBC reported last week that companies across industries are raising prices for the end-consumer as a way of tackling higher costs. Higher prices are a very efficient way of stumping demand for pretty much anything beyond basic necessities such as food — which, by the way, is also getting more expensive.

One might argue that pent-up demand and higher levels of savings will keep demand for everything alive and well but savings only last for so long and pent-up demand eventually dries up. The question then, would be which runs out first, savings money or relatively affordable products.

When it comes to energy, things are a bit more complex than consumer products. U.S. shale oil producers have always emerged from price crises by immediately starting to raise production, until now. Now, despite higher international prices, shale drillers are being cautious with output increases. So is OPEC+.

While oil producers are being cautious by choice, since they could only benefit from higher oil prices coupled with higher demand, for solar farm builders the situation is a lot different. With higher raw material prices, their products are becoming more expensive and there is precious little these companies can do to counteract the cost curve but make their product more expensive for its users, proving the proponents of Wright’s Law in renewable energy wrong.

The situation with electric cars is pretty similar. Higher battery mineral prices as well as higher steel and copper prices are effectively making EVs more expensive and this is happening at a time when carmakers are trying to make them as affordable as possible to stimulate uptake.

There’s more, too, this time from EV charging station builders. That an extensive network of charging points is a must for any country that wants to electrify its passenger transport, is blatantly obvious. Yet this segment of the EV industry is caught in something of a Paragraph 22, at least in the U.S.: to ensure the charging points will be profitable, their builders need to know that enough people will buy EVs. But the only way to be reasonably sure that enough people will buy EVs is to build more charging points. For now, charging point builders are moving in the dark

In both these cases, governments can step up subsidies. This would be the simplest solution to the raw material supply crunch. But subsidies are tricky as China recently discovered, when its subsidy bill to solar and wind power producers swelled to unsustainable levels which prompted the government to slash the financial incentives and halt them altogether for solar farms and onshore wind farms.

The inflation debate, meanwhile, continues. Some see the current levels of price rises as something normal and to be expected at this stage of economic growth. Others are more pessimistic and worry about inflation becoming a serious problem in some economies, perhaps most notably the U.S. There is more than one reason for these worries but it all, again, comes down to shortages, of workforce or money in the bank to finance costly government programs for economic recovery.

The situation is not much different in Europe, where the EU has tied member states’ economic recovery to spending on green energy and digitalisation. With the rising costs of some key elements of what we call green energy for reasons of convenience, the amounts earmarked for these investments would not go as far as they might have under other supply and demand circumstances. The EU might need to dig deeper into its pockets to hit its ambitions emission targets, which also include compensations for the more “energy backward” member states. This, in all likelihood will fuel further inflation, over a longer term.

What is happening right now could have easily been foreseen. As already mentioned, economic growth and contraction follow a pretty clear pattern, and even though the degree of contraction caused by the pandemic was unusually high, the massive effort put into returning GDP on the growth course could only lead to one thing: higher demand for everything, driving higher prices. Many did foresee it. Some ignored it.

In June, U.S. inflation hit 5.4%, the highest since August 2008. The Fed’s projection for the full year is for 3.4%. That’s still well above its own target of 2% but some in the Fed believe the current inflation rate is only a temporary problem, to solve itself. Others, meanwhile, believe it is a serious problem. The central bank is meeting this week to discuss QE tapering.

Maybe the problem will solve itself, as supply chain disruptions are gradually fixed. Or maybe, now that media are once again reporting rising Covid-19 cases across the U.S. and much of Europe, the pendulum will swing back towards purse-tightening again before long. At least that should push prices down, including those of solar panels and EVs. This will be important: energy inflation, after all, is the root of higher prices for thousands of other things.