Another look at inflation: Not so fast...

Although inflation remained conspicuous by its absence last year, there has recently been much discussion of the idea that the world might be standing on the cusp of a new regime of inflation.

Certainly, it seems possible that fears of inflation might be awoken this year. The re-opening of the services sector and base effects on energy-price inflation (caused by Covid’s impact on oil prices in 2020) seem likely to be supportive for both headline and core measures of inflation.

US inflation (year-on-year %). Base effects will be very supportive from April onward, which may reinforce the inflationary narrative

We would argue, however, that a temporary increase in inflation should not be confused with a persistent pricing problem. We may indeed see higher levels inflation than we have recently experienced. But we must not lose sight of our starting point: central banks have consistently under-delivered relative to their inflation targets; and monetary policy is largely exhausted.

Furthermore, the structural disinflationary forces that have been at work throughout the global economy for years are unlikely to dissipate: technological innovation, low economic growth and high savings rates will continue to exert downward pressure on inflation and provide a counter-balance to the inflationary risks of de-globalization and inward-looking populist movements.

The challenges central banks face in delivering inflation …

In recent years, low inflation – and the risk of outright deflation – has preoccupied markets. This has taken place in an environment in which unemployment rates fell below what had once been regarded as the ‘natural’ rate of unemployment. In Japan, the country that has been charting the course many observers expect Western economies to follow, unemployment fell to 2.3% in December 2019 – but inflation has hardly been positive.

We should not forget that when the Bank of Japan introduced its ‘Yield Curve Control’ policy in September 2016, it also announced an “inflation-overshooting commitment”. Their statement of intent, in many respects, is similar to the approach that other central banks have adopted more recently. Japan’s experience over the past four years would suggest, however, that expressing a commitment (or perhaps desire) to hitting an inflation target and actually doing it are two quite different things.

Reflect on the situation that central banks face: either they have too much ‘credibility’ as inflation fighters – or they have a problem. To frame that differently, their credibility has created a problem as monetary policy reaches the limit of what it can achieve.

Over the very long term – centuries – volatility in inflation has been falling. Chart 2, for example, shows data from the Bank of England measuring the volatility of inflation reaching back to 1230.

Inflation and volatility in the inflation rate have declined steadily over the very long term. UK annualised standard deviation of inflation and long-term moving average

This dynamic, however, is not unique to the UK. In fact, we can observe that the level of inflation and its volatility have decreased materially over the past five decades in both developed and emerging economies.

In itself, this outcome should be celebrated. Central banks’ independence and credibility has reduced price uncertainty, lowered the inflation premium and so supported planning, investment and therefore economic activity.

But in a world where inflation has generally been skewed to the downside and where monetary policy has become stretched to the limit, this dynamic could become problematic.

Over the past three decades, we have seen an increasingly negative skew in inflation expectations, as the St Louis Fed’s price pressure measures reflect. Since 1990, the perceived probability that the following 12 months would witness price deflation has spiked on several occasions. Meanwhile, over the same period, the probability that US personal consumption expenditures (PCE) inflation would rise above 2.5% has consistently declined. This could be a reflection of decreased inflation volatility and the low level of realised inflation feeding through to, and so influencing, expectations for inflation.

Since 1990, the perceived threat of inflation in the US has declined while worries of deflationary episodes have become more frequent and severe.

St Louis Fed price pressure measures, showing probability of PCE inflation above 2.5% and deflation over the next 12 months.

In its Statement on Longer-Run Goals and Monetary Policy Strategy (amended on 27 August 2020), the US Federal Reserve re-stated that “the inflation rate over the longer run is primarily determined by monetary policy”. The evidence of the past 11 years suggests this is debatable.

The San Francisco Fed’s decomposition of the PCE ‘basket’, shown in Chart 4, illustrates that, from the early 1990s, the 10th percentile of the basket (below which 10% of the least inflationary – or most deflationary – readings are found) has acted as a constant drag on overall inflation. The consistency of this dynamic across economic and monetary cycles reflects how ineffective monetary policy can be in certain areas of the economy: prices across large parts of the economy are influenced by (global) dynamics that lie beyond the control of domestic monetary authorities.

There is a limit to what national central banks can do… 

Significant deflation in the prices of some goods (the 10th percentile of the PCE inflation basket, where deflation is most pronounced, shown in blue here) have largely offset inflationary pressures in other areas (shown by the orange line, the 75th percentile of the inflation basket) holding down overall inflation (grey line) despite dramatic monetary easing.

As we can see in this chart, on average since 2009 monetary policy in the US has been highly stimulatory - yet the Fed has been unable to deliver its inflation target. The cumulative undershoot of PCE inflation relative to the Fed’s target since September 2009 is over 5%.

US inflation consistently below target

Even the Fed now appears to doubt whether it can achieve its target. In its most recent Summary of Economic Projections (published on 16 December), the median Fed funds rate projection for 2023 remains at the current 0.1% (with a range of 0.1-1.1%) – far below a long-term median ‘neutral’ level of 2.5%. Unemployment is expected to fall to 3.7% (below the 4.1% NAIRU). Yet inflation is shown as only just getting back to target at 2% (within a narrow range of 1.7-2.2%). In other words, monetary policy is expected to be at full throttle for the foreseeable future, yet inflation is only forecast to just get back to target by 2023, with the risks skewed to the downside.

As we have seen in Japan, a central bank’s desire to hit its inflation target and its ability to do so are two very different things. The European Central Bank may be suffering the same fate: realised inflation has consistently fallen short relative to its staff’s macroeconomic forecast.

We have reached a point where the impact of monetary policy measures is asymmetric. The marginal benefit of further loosening is meaningless – and potentially even negative. Beyond supporting overinflated asset prices, the benefit of greater easing is minimal. On the other hand, leverage is so elevated that even a small increase in interest rates would deal a disproportionately large blow to consumption, solvency and investment. This dynamic makes ‘normalising’ rates almost unimaginable.

Our conclusion is that, aside from waiting and hoping, there might be little more that central banks can do to stimulate demand, particularly given the strength of the disinflationary dynamics they continue to face.

The persistent dynamics of disinflation …

Over the last couple of decades, a number of structural shifts have contributed to the disinflationary dynamic. These are not going away; some have actually intensified.

Energy prices: supply and demand

Shale gas has permanently altered the supply-demand balance for energy. Energy supplies have become far more dynamic and price elastic. The US, once a net oil importer, is now a net exporter. This energy revolution will prevent persistent increases in energy prices, which were a key source of inflationary pressures in the wider economy during 1970s and 1980s.

The Biden administration might well choose to relax some of the sanctions imposed on Iran, further increasing potential energy supplies. And as technology improves, shale-gas deposits that are currently rendered inaccessible by complex geological formations will become exploitable, further increasing supply.

On the demand side, meanwhile, the trend in global growth has been moving lower for decades, as Chart 6 illustrates. Several factors were supportive for economic growth after World War Two. Baby boomers entered the labour force, the female participation rate increased, access to credit was democratised and post-war reconstruction efforts boosted growth. Today, however, these supportive trends have dissipated – or gone into reverse.

As baby boomers continue to retire, the labour force in developed economies will shrink, in some cases dramatically. Pushing the retirement age higher to slow the shrinking of the labour force – or somehow delivering a substantial jump in productivity – would be required simply to maintain economic growth at its current modest level, let alone reverse the downward trend.

This lower growth rate will weigh on demand for energy and, in conjunction with more dynamic, price-responsive supplies of energy, limit any price increases. Fears that the world might be running out of oil look badly outdated and the oil-price shocks of 1973/74, 1979 and 1986 seem likely to be a thing of the past.

OECD real GDP growth

Technological change and the post-Covid economy

To this point, the pandemic has proven to be deflationary: it has dramatically accelerated a number of existing trends, the effect of which has been to increase competition, so further reducing pricing pressures.

As Chart 7 shows, e-commerce exploded during the pandemic as lockdowns forced shoppers to turn to the internet, thereby increasing price transparency and competition. In November 2020, online sales accounted for 14.5% and 31.4% of all sales in the US and UK respectively. The share of online shopping in many other developed economies, however, is still far lower than in the UK and US, leaving it significant room to grow. In Spain, for example, e-commerce only represents 7% of retail sales. As online stores displace physical retailers, price competition will only intensify.

Online sales as a proportion of retail sales have increased exponentially over the last few months

In addition, the move to working from home will reduce the demand for office space and for business travel. It may even potentially exert downward pressure on wages as people accept lower compensation in exchange for greater flexibility and for the ability to move away from costly city centres.

Social distancing has also accelerated the adoption of automation and the usage of robots. As with online retail, this trend was in place well before the pandemic – but it has gathered significant impetus over the past 12 months, with the adoption of artificial intelligence spreading much further and reaching into new industries.

Demographics and the savings rate: disinflationary – for now…

Overall, we expect demographic trends to continue exerting disinflationary pressure over the coming years. We acknowledge, however, that the continued aging of the population and the reduction of the workforce in developed economies might eventually start supporting wage inflation.

In the short-to-medium term, the baby boomer demographic will continue saving ahead of its retirement, acting as a drag on economy activity (goods foregone) and so on inflation. It may even be possible that persistently low levels of interest rates are actually increasing saving rates as workers calculate that more needs to be put aside to achieve a targeted level of retirement income.

In years to come, however, it is possible that the bargaining power of those in the shrinking workforce could increase, reawakening the dormant relationship between unemployment and wages. As the population ages, health and pension costs will inevitably increase, the balance between saving and investing will shift as an ever-larger proportion of the society retires and begins cashing in its investments to pay for its retirement. This dynamic, however, is unlikely to take place soon. In recent years, many economies have actually seen an increase in the participation rate of workers aged 55 years and over, which should postpone the tipping point.

Retirees (>65yr) as a percentage of working age population (15-64yr) across several economies.

Pro-inflationary structural drivers – is inflation the only ‘answer’?

We should acknowledge that not every structural change currently unfolding will fuel the disinflationary dynamic. Quite the contrary. Most notably, fiscal policy will be resolutely stimulatory for the foreseeable future. The aging of the population makes cuts in pension and healthcare costs inadmissible. Upsetting an ever-bigger section of the population with a very high propensity to vote would be political suicide.

On the other hand, inter-generational inequality has clearly been accentuated by the pandemic: younger population cohorts are suffering high levels of unemployment and are increasingly unable to afford inflated asset prices, particularly housing.

So voters with assets are politically untouchable, while those currently without will be contributing to the system for the next few decades and cannot be neglected. How can this circle appear to be squared? Through the promises of politicians: promising everything to everyone delivers electoral victories.

In an environment where debt has been accumulated at a frantic pace (see Chart 9) and where more borrowing will be required (not least to fund the cost associated with the aging of the population), inflation may be the only viable solution to transfer wealth from creditors to debtors. It is certainly more subtle thandefaulting.

Debt: Where we are now…

Debt: Where we’re going

Long term debt dynamics are likely to deteriorate further. Health and pension spending will increase with the aging of the population.

This political environment could eventually put the hard-fought independence and credibility of central banks at risk. With depressed inflation, any monetary policy tools – such as open-ended QE and negative interest rates – seem permissible and even wise. That might not be the case if headline inflation moves beyond the target. Inaction when faced with strong economic growth and inflation moving towards (or even above) target will inevitably call the independence of central banks into question. This is unquestionably a risk that we have to consider given the close relationship between the actions of central banks and governments’ fiscal measures.

De-globalization

Populism poses one upside risk to inflation and the associated trend of de-globalization is said to offer another. If it happens, however, ‘re-shoring’ will be a slow process. Supply chains might well become shorter and the West’s reliance on Chinese companies and products might diminish. But producing goods in developing economies is still much cheaper than it is in the West.

If we look at the way trade volumes have contracted and rebounded since the end of 2019 and compare them to the global financial crisis, the picture is an encouraging one. As Chart 11 shows, during the global financial crisis, it took 20 months for world trade volumes to recover to their August 2008 levels. This time, however, around it took just five months. Disentangling the interdependence of the global economy might prove to be more of an intellectual discussion than a practical reality.

In the current crisis, merchandise world trade volumes have recovered much quicker that they did following the global financial crisis

It is indisputable that the long march of globalization has been disrupted and might even be partially reversed. It is also true that nationalism tends to be inward-looking and therefore inflationary. But the power of political movements to buck global economic trends should not be overstated: any de-globalization is likely to be both limited and slow. Political rhetoric and economic reality might contradict each other.

Conclusion

The change in policy mix, with looser fiscal policy complementing monetary policy, along with the re-opening of the service sector and positive base effects as energy prices recover relative to last spring, seem certain to create a conducive environment for inflation in the short term.

This will be further reinforced by the change in the reaction function of central banks. As it clearly expressed in its Statement of Long Term Goals, the Federal Reserve under Powell intends to be reactive with respect to inflation rather than proactive as it was under Yellen. This will demand a higher inflation premium.

We would argue, however, that the last 20 years have shown that a positive impulse from fiscal policy will be needed to avoid continued undershooting of the inflation target. This is even truer now that monetary policy has reached its limit. The structural disinflationary drivers caused by technological innovation have not dissipated – on the contrary, some have gained strength and speed. Ultimately, we are in the middle of a disinflationary industrial revolution that is permeating the global economy.

Investors should therefore acknowledge the inflationary narrative in the short term, but they must not lose sight of the real risk: disinflation in an over-leveraged world.