The 3D Reset: how it’s changing the inflation outlook

Major shifts in the three areas of decarbonisation, demographics and deglobalisation are expected to have significant long-term implications for the global economy. Importantly, these “3Ds” will likely result in higher and more volatile inflation.

Central banks are currently raising interest rates to bring inflation to heel. If they succeed, as expected, it seems very likely that the cost of doing so will be an economic slowdown, and recession in some instances.

But even once the immediate problem is addressed, inflation pressures are set to persist in the new economic regime. This seems likely as the “3D Reset” exposes demographic vulnerabilities, challenges globalisation and accelerates decarbonisation trends.

New economic regime and demographic vulnerabilities

Problematic re-openings following the initial pandemic lockdowns of 2020/21 gave us the inklings of a possible break in regime.

The intense goods price inflation seen during this period contrasted vividly with the previous three decades when globalisation had contributed to a long-term decline in prices (see chart, below).

More worryingly, services inflation then took off in advanced economies, as restrictions on movement were relaxed. This was driven by wages as a result of pandemic-related labour shortages and signalled inflation had become engrained in domestic economies.

These trends are subsiding as the major central banks now seem to be getting on top of the problem. But the 3D Reset leaves lasting vulnerabilities, not least those related to rising protectionism.

One of the consequences of such policies are fewer options to manage the longer-term trend of falling labour participation rates as populations age. Boosting labour supply by relaxing immigration controls, for instance, seems unlikely in post-Brexit UK, post-Trump US, and increasingly in Europe too.

These, and other geopolitical changes have been chipping away at globalisation for some time, long before the pandemic and Russia’s invasion of Ukraine.

Diminishing globalisation benefits

When globalisation was in full flight between the mid 1990s and early 2000s many countries enjoyed low and stable inflation. Price stability was one important aspect of the globalisation “dividend”.

Stability, however, morphed into lowflation after the 2007/08 Global Financial Crisis (GFC), when there was the constant threat of deflation (falling prices) in the West – arguably as corrosive to confidence as high inflation.

Central banks cut interest rates to zero to stimulate growth and maximise employment (one of their other mandates, aside from stable prices).

When inflation returned following the pandemic, central bankers initially believed it would subside by itself without the need for higher interest rates.

It would be a case of waiting for the external price shocks caused by Covid-19 (goods prices) and then the war (commodity prices) to wash through the system, so they thought. It became apparent, however, the world had moved into a more permanent state of supply shortages and more frequent price increases and a new economic regime.

Central bankers realised there would again indeed be a cost for taming inflation. The inflation growth trade-off had returned from its long absence during the Non-Inflationary Consistently Expansionary, or “NICE” era.

And less supportive globalisation trends, including less flexible labour markets, look set to continue frustrating hopes of a return this era (see The 3D Reset: deglobalisation).

Azad Zangana, Senior European Economist and Strategist, says:

“While we are not expecting a return to 1970s and 1980s, the global economy is likely to continue to face inflation and ongoing labour shortages, pushing labour costs higher.

“Economies must also learn to cope with rising structural inflation associated with political fragmentation and the response to the new economic order.”

Under the inflation growth trade-off, interest rates need to rise enough to induce an economic slowdown, to curtail wage growth driving services inflation, and more generally core inflation (which strips out volatile energy and commodity prices).

The alternative is to risk an unhinging of inflation expectations, as occurred in the 1970s and 1980s, when workers were demanding and achieving much higher pay increases, even after inflation had begun to moderate.

The loss of price stability resulted in wage price spirals as the cost of pay increases had to be passed on to consumers in the form of price rises, and so the cycle continued. It took multiple rounds of interest rate rises and we saw the worst possible economic trade-off occur, otherwise known as stagflation, being a combination of slowing growth and accelerating inflation.

Circumstances today might not be as challenging as then. Labour shortages and wage pressures, however, will likely to persist into the medium term – remember there are still almost two job vacancies for every unemployed worker in the US (see chart, below).

For a summary of how demographic trends are likely to impact the inflation outlook see: The 3D Reset: demographics

Decarbonisation – adding to inflationary pressures

Linked to many of these changes, energy security issues highlighted by the Russia-Ukraine war have added urgency to efforts to transition to green economies.

This process of decarbonisation will likely prove be very expensive (see The 3D Reset: decarbonisation).

Stricter carbon pricing is likely to drive fossilflation over the next decade and will be hard to escape in the early stages of the energy transition as putting a price on pollution drives up energy and electricity prices in particular.

Meanwhile, greenflation will be another inflationary consequence of decarbonisation due to a shortage of key minerals required to create new renewable power generation infrastructure, and greener transportation and heating systems.

While rapid green technology advancements will offset these inflationary impacts, they will take time to come through.

For a description on highlighted words see: The 3D Reset: the economic terms you’ll need to know