Inflation - dormant or dead?
The theme of "lower for longer" has become the norm driven by the belief that inflation has been extinguished. Nobody is currently worrying about inflation, but what if we're all wrong? There are some factors that could take us by surprise.
The most violent reactions in financial markets tend to occur when deeply held beliefs are suddenly shattered. Two prominent examples were the ‘new economy’ mantra of the late 1990s and the dogma that US house price could not fall in aggregate.
Today, one of the deepest convictions is that inflation has been extinguished and consequently interest rates can stay low for a very long time.
There are many good reasons why inflation is currently low and likely to stay low for the foreseeable future. Indeed, we have written about the likely overstatement of current inflation. We also worry about a China hard landing, the proliferation of political risks and the global debt overhang which makes growth vulnerable to modest rises in interest rates. Lots could go wrong to undermine demand and prevent inflation from flickering and even if these risks don’t materialize, there are structural forces (such as increased automation and price transparency) which could be keeping inflation at bay.
However, here are six factors worth contemplating which could lead to higher inflation:
- Labour markets are tightening. The global financial crisis created lots of unemployment. It has taken time to absorb the slack, but despite somewhat disappointing growth, unemployment has continued to fall across most developed markets. The Phillips Curve might appear flat, but once full employment is reached, it could curve steeply upwards and wage pressures appear.
- The end of globalisation. The opening up of markets and increase in trade has been a major disinflationary force. Now protectionist rhetoric is on the rise with both US presidential candidates appearing hostile to the Trans Pacific Partnership (TPP). As the backlash to outsourcing and free trade grows, consumers could face higher prices from domestically sourced goods.
- Monetary policy. Being stuck at the zero bound leads to an asymmetric reaction function from central banks. They are more inclined to keep rates lower for longer and gamble with an inflation overshoot, than risk premature tightening and then be faced with having to resort to increasingly unorthodox policies to combat the liquidity trap.
- Low productivity. While weaker productivity growth argues for lower neutral real interest rates, if aggregate supply is increasing more slowly, it takes less of an increase in aggregate demand to generate overheating. If global growth picks up by more than expected, the global economy could quickly run into capacity constraints.
- Commodity prices. The commodity bust over the last couple of years has added to global disinflation. The collapse in commodity investment could reduce future supply and has potentially sowed the seeds for the next price recovery cycle.
- Fiscal policy. If governments decide to abandon their commitment to reducing deficits and take advantage of low borrowing costs, this should boost aggregate demand. The effect could be amplified by additional QE in some countries. At the most extreme is ‘helicopter money’. This could have a profound impact on inflation expectations and is a topic we intend to write much more about in future months.
I don’t expect an inflation outbreak anytime soon, but it might be worth taking out some cheap insurance before anybody else is worrying. Indeed, in many places there appears to be a lack of confidence in the ability or willingness of central banks to get inflation to their targets. My colleague Chris has identified which markets offer the best value for protection against an inflation scare.