The election, protectionism and the return of inflation

The 2016 U.S. presidential election may succeed where the world's central banks have failed, but not as they would wish: in bringing back inflation through protectionism.

One of the most striking aspects of the election campaign is the way in which Donald Trump and Bernie Sanders are attracting support by attacking trade deals they see as robbing Americans of jobs and wages on unfair terms.

Not only has Trump called for a 45 percent tariff on all imports from China, but Bernie Sanders, speaking last week at a debate in Flint, Mich., said current trade policy was responsible for "Not only job loss by the millions, but a race to the bottom so that new jobs in manufacturing in some cases pay 50 percent less than they did 20 years ago. How stupid is that trade policy?"

Even Hillary Clinton sounded very little like an advocate of free trade in Flint, stressing that she had voted against the only trade pact to come to a vote in her time in the Senate and had come out against the proposed Trans-Pacific Partnership agreement. To put this sea-change in perspective: Clinton, in 2012 as secretary of state, called the then-embryonic TPP the "gold standard in trade agreements."

Discount all this as you see fit as election rhetoric, or as unlikely to come to fruition, but the fact remains that the conversation in the U.S. about the benefits of unrestricted trade has changed. Whoever wins the White House, or seeks national office is likely in the future to be more willing to impose barriers to trade and less secure in their ability to argue for lower tariffs and more open trade.

Indeed, it is perhaps no coincidence that the U.S. last week slapped a 266 percent tariff on some imports of steel products from China and a lower levy on six other countries.

There are any number of economic consequences of this, including potentially lower, though more equally shared, economic growth, but one stands out as an easy call: trade barriers are inflationary. The erosion of the long-standing, broad, cross-party consensus on trade is a big deal, and perhaps a very inflationary one.

Good or bad, just or unjust it may be, but a U.S. which is more willing to build moats and walls around its economy is one which, all else being equal, will have more inflation.

And of course, trade is a relationship rather than something one side dictates, and if the world's consumer of last resort is raising tariffs you can expect others to do so as well, theoretically sparking inflation elsewhere.

Falling inflation and bouts of deflation have roughly paralleled the huge increase in global trade which came as China was, and other emerging markets were effectively, integrated into the global economy. That fall in inflation might have other causes, notably the aging of populations in developed economies, but offshoring of manufacturing also played a role in driving down the price of manufactured goods like electronics, clothing and even some food.

This global competition has global impact, keeping a lid on price rises in emerging markets and developed economies alike. It is striking the way in which tariffs have declined along with global inflation in recent decades. Average world tariff rates were 30 percent in the early 1980s, spiking as high as 40 percent in the early 1990s and then steadily declining to roughly 6 percent by 2010, according to World Bank-derived data. Global inflation traced a similar path, from as high as 30 percent in the 1990s to about 3.3 percent today.

A rekindling of tariffs, much less trade wars, would likely drive inflation higher while doing it in a way that is negative for growth. This will be an extremely unpleasant puzzle for central banks to solve, making the current search for inflation seem simple and risk-free in comparison. At the very least you can expect increased political pressure on central banks.

Trade policy as it has been practiced over the past 30 years has been asymmetrically positive for corporate profits for multinationals which can move production and build a global supply chain. Less of the economy goes to labor and companies have often been good at gaming the system to protect themselves, and their profit margins, from competition. Look for falling margins and rising wages, all with higher rates as a backdrop.

Could be tough times ahead for investors.