Inflation, anyone?

Since the Federal reserve and just about every Western country tried to reflate us out of the 2008 depression, there have been many people crying INFLATION.

Inflation creates a specifically strong reaction amongst many (older) people who’s parents or grandparents were ravaged by  inflation during the middle of the 20th century or who bore the brunt of inflation in the 1970s.  Even in my career I remember increasing prices four times a year in the 1980s to counter rampant inflation. I had a first house loan of 21% p.a. and salary increases of 15-25% a year were not unheard of.

But can this type of environment come back?  It appears that some US commentators think so…

As you can see from the lower right corner of exhibit 1, the number of commentators who doubt inflation will occur has dropped quite dramatically in recent months. As we entered 2016, approx. 40% thought there would hardly be any inflation when looking five years out. That number has since declined to less than 10%.

As you can also see, whilst the number of those commentators who believe inflation will return have increased over 2016, they still only account for 20%. However, a much larger percentage (now about 70%) subscribe to the middle road outlook – a rather benign inflation environment of 2% +/-. This range is typically viewed as constructive for economic growth and for equity prices, both of which tend to do best, when inflation trades in the range of 1.5-2.5%.

But will this come to pass?

To assess this we need to look at what actually causes inflation- its certainly NOT government banks printing money as we’ve been doing that for ten years with no impact. There must be something more.

It could be said also that central bankers are more worried about inflation than they have been for a while – at least in the US and UK – and the concerns to a large degree are a consequence of the low output gap in both of those countries (exhibit 4). The output gap is the gap between the capacity of an economy to produce and the capacity of that economy to consumer. Continued economic growth combined with low corporate investments for an extended period of time have had the effect of absorbing a significant part of excess capacity, leaving both economies exposed to bottleneck problems. The output gap has narrowed significantly.

This may signal that with growing demand for goods in US and UK, and a lack of capacity to supply these, prices rise, creating an inflationary environment.  OK there is the potential for inflation in certain sectors in US and UK.

So where are consumers seeking to spend more money… in the US this is set out below

US consumer are looking to spend more on healthcare and housing two sectors where there has been little investment, which may signal inflationary problems as neither can be imported- unlike energy for example.

What about Europe?

Years of poor economic growth in the Eurozone has left a much bigger output gap there. The gap obviously varies from country to country, but nowhere is it as low as it is in the US.

Figure 1 displays the different patterns of how the GDP output gap developed in six euro area Member States since 2010. While Germany remained relatively stable after the peak of the sovereign debt crisis in Europe, Austria, Italy, Portugal, and Greece produced goods and services far below their potential GDP estimates, albeit to a differing degree  In 2012, the output gap in Austria was -0.94% but -3.89% in Italy, -6.99% in Portugal and -12.6% in Greece. The development in Ireland illustrates the same downward trend up until 2013, but a more rapid recovery thereafter.

Secondly, a much older population in the Eurozone (exhibit 8) will result in more dramatic changes near term. A much faster growing number of elderly will change (reduce) consumption patterns more quickly, and economic growth will almost entirely disappear in the years to come.

So comparing the US with Europe highlights the three major challenges the world is dealing with at present:

  • ‍An ageing population
  • Excessive amounts of debt everywhere
  • Declining spending powers amongst the middle classes

Critically, it seems that all these dynamics are deflationary. The lessons from Japan clearly illustrate that ageing has had deflationary impact for years.

As the Eurozone continues to suffer from bad demographics, exceedingly high levels of debt, and a large number of middle-class people who suffer from shrinking living standards, it can only be concluded that the longer term structural inflation trend in Eurozone is down, reduced inflation if not negative inflation.

That said, neither the UK nor the US are in a dramatically better situation. Both countries will be negatively affected by the same three structural trends, even if the absolute impact is likely to be less severe.

As a consequence, I can only reach one conclusion and that is that, in the longer term, inflation will continue to fall, and as a result so will interest rates. What we are witnessing now is a short-term spike in inflation driven by cyclical and other short-term factors. And you should continue to see occasional spikes in inflation, even if the longer term structural trend line continues to point down.

What about China?

The Chinese economy is much less developed than the economies discussed so far and, as a result, is subject to very different dynamics. Building out the infrastructure is a very substantial part of the growth story here, and infrastructure building requires commodities. Consequently, commodity prices have a much bigger impact on overall inflation than in the west. In fact, there is almost a 1:1 relationship between commodity prices and producer price inflation in China (exhibit 10).

But, given the slowing pace of GDP growth in many parts of the world, we should expect a structural oversupply of many commodities in the years to come. Strong GDP growth in China won’t entirely make it up for weak growth elsewhere in driving commodity pricing upwards.

As we also know, China’s population is not exactly youthful, and with the one child policy coming into parental mode, don’t expect a significant growth in the youth population for two generations. Added to this are the excessive amounts of debt that is an even bigger problem in China than the west. In other words, two of the three structural trends mentioned earlier also point towards lower inflation in China over time. If commodity prices also were to ‘underperform’, China may actually be able to continue its growth programme at very modest inflation levels.

So after this long explanation, shouldn’t our views be crystal clear. Although there is a meaningful risk of rising consumer price inflation in the short term, I see little to worry about longer term- no worry of inflation. In that context, I ought to mention a one issues.

In the US, the composition of the FOMC changes regularly, and the upcoming changes are likely to make it even less hawkish than it has been more recently with the outcome that rate hikes are less likely. Plus Trump gets to nominate a Chair and Deputy Chair soon, its likely that these would be dovish and pro-business, so unlikely to increase rates. Which sets another cap on interest rates and likely drives the value of the US$ lower reducing any inflation from a rising currency.