When the Federal Reserve and other central banks introduced quantitative easing in response to the global financial crisis, the loudest and most persistent criticism was that such actions would unleash a major surge in inflation. The reality has been very different.
Inflation has persistently fallen short of central bank targets and economic forecasts for the past six years. Its failure to pick up materially is made all the more mysterious by the fact that the global economy has been improving and unemployment falling. Nevertheless, asset prices have appreciated significantly in recent years and the data captured by official measures of inflation have been called into question.
There is growing concern that despite the absence of inflation so far, central bank actions may be storing up future inflation risks, and investors should not be lulled into thinking the recent period of low inflation will continue indefinitely.
Explaining low inflation
The current weakness of inflation is sometimes explained away as the result of a number of transitory, short-term factors. For example: currency appreciation may have weighed on domestic inflation by reducing import prices; or one-off shocks, such as a fall in telecoms prices, may have distorted the data; or previous declines in commodity prices just need time to work through the system before dropping out of the data.
None of these explanations is especially convincing. Currency appreciation in one country can’t really explain global inflation weakness, as there must be offsetting currency depreciation elsewhere; so-called one-off shocks are too common to be truly “one-off”; and commodity price weakness can’t really explain the weakness of core measures that strip out commodity price movements.
So to explain the weakness we need to turn to deeper, structural changes in the economy and the nature of the inflationary process itself. Standard economic models describe inflation as partly a function of the degree of slack – or under-utilised resources - in the economy. As spare capacity falls, this should put upward pressure on prices as the competition for resources grows. So one possible explanation for the weakness of inflation is that, despite unemployment falling significantly in the US and UK, there is simply still more spare capacity in the economy. On this view, it is only a matter of time before falling spare capacity finally results in a pick-up in inflation.
Flat Phillips curve?
It may be that slack (or the lack of it) doesn’t really drive inflation any more. Put another way, the Phillips curve, which links inflation and unemployment, may have become very flat. There are a number of reasons why the trade-off between unemployment and inflation may have broken down, causing the curve to flatten. The bargaining power of workers has been under pressure due to de-unionisation of the work force, the rise of the “gig economy” and informal employment arrangements, and greater competition in developed markets from cheap overseas labour.
The flatness of the Phillips curve may prove to be a temporary phenomenon, and the process could turn out to be self-correcting. Diminished bargaining power and stagnant wages may lead to a loss of political support for globalisation and free trade, and to policy changes that boost workers’ power. Indeed, there are signs that this might already be happening in the US and the UK. Globalisation does not necessarily have unstoppable forward momentum, and the forces that may have been pushing down inflation could be reversed.
Another suggestion is that firms’ pricing power has fallen as they contend with online price comparison sites and big online retailers like Amazon, and they are less able to push through price increases to consumers. However, while companies in some emerging markets may have struggled with falling pricing power due to cyclical weakness in their domestic markets since 2010/2011, firms in developed markets have posted impressive margins since the crisis. Recent economic research suggests that firms have seen their pricing power increase over the past 30 years. If anything, this rise in market power might have put a little upward pressure on inflation.
In emerging markets, other institutional and structural changes seem to be pushing down inflation, partly because policy makers are concerned that excessive inflation will undermine social stability. Many emerging market central banks have adopted inflation targeting, going out of their way to demonstrate ’credible’ behaviour. For example, the Russian central bank hiked rates during an inflation spike in 2014. Another important structural change in emerging countries is that increased energy efficiency seems to have reduced the pass-through of rising energy prices into inflation.
The Phillips curve appears to be alive and well when looking at more granular, local-level data – for example, in US city municipalities there is a clear relationship between cities with higher unemployment having lower wages, and vice versa. Slack appears to remain as a key determinant of inflation - and, given time, it will eventually pick up.
It may be that nominally independent central banks are not really as independent as they seem.
How independent are central banks?
Central banks are meant to target inflation, and so a pick-up in inflationary pressure should cause them to tighten monetary policy. However, it may be that nominally independent central banks are not really as autonomous as they seem, or as committed to their inflation targets as they claim. As central banks have taken on more responsibility for issues like financial stability, it has become easier to excuse missing inflation targets, as they can switch to justifying their policy in terms of whatever target is most convenient at that time. Furthermore, monetary easing following the financial crisis may be responsible for an unhealthy increase in asset prices. Low risk-free rates have pushed investors up the risk curve, with the effects being seen on asset prices across the board. Central bankers tend to ignore asset prices beyond the impact that they have on the real economy, but they may be sowing the seeds of a future crisis. That said, shorter-term investors may remain confident that this will not play out over their investable time horizon.
Central bankers are appointed by politicians, which means they can never truly be independent of the political process. And politicians may not especially value price stability, given high levels of outstanding public debt and a desire to see a strong economy to get re-elected. President Trump has an opportunity to reshape the leadership of the US central bank over the next year, so his appointments will be an important test of how well central banks are able to withstand politicisation. In the meantime, it is unlikely that central banks will deliver a significant interest rate-hiking cycle. Rhetoric suggesting much in the way of ‘normalisation’ should be heavily discounted.
Implications for investment
If inflation picks up, what are the implications for investment portfolios? It may be that ‘real assets’ like alternatives and equities will prove to be better investments than ‘nominal assets’ like government bonds. Markets’ ability to function efficiently, if a less benign scenario develops, may be compromised by the 'all face the same way' environment. The days of offsetting flows and contrarian investors have been severely compromised, and there is little opportunity to hedge efficiently.
Overall, investors’ relatively sanguine view that inflation will never pick up may be misplaced. We predict a modest increase over the next three years. As and when inflation does become a problem, it is unclear whether central banks and policy-makers will have sufficient capacity to mount an effective defence given the low level of rates and already stretched balance sheets. Inflation isn’t dead, it is merely asleep.