Will inflation ever increase?
This is the question investors are asking – we have to look back decades to find such a protracted period of low inflation, especially with monetary policy so loose, and oil prices so high.
Sleepy inflation seems at odds with a rebounding economy and decades of low unemployment: on balance, we believe current low levels of inflation and expectations that it will remain low are justified for structural reasons.
However, the risks to our Goldilocks inflation view will become increasingly skewed to the upside, as geopolitical tensions rise.
Inflation effects
Why is contained inflation our base case? Headline inflation has accelerated over the past two years, partially because of rising oil prices. But the latest run-up in oil has been overdone, and prices will retreat over the next two years.
That said, oil prices also look likely to stay elevated for the rest of the year as a result of supply constraints. This could add inflationary stress to oil-importing countries, but will likely have only a temporary effect on the US, given the supply of domestic production and the less energy-intensive nature of the US economy.
Hence, global inflation should stabilise close to current levels, especially as there has not been the spillover to wages necessary for it to become entrenched.
Core personal consumption expenditures inflation has also accelerated, but there appears little reason to anticipate an upsurge, even though we expect unemployment to fall further.
And wage inflation remains contained, although the employment cost index suggests some pick-up among private industry workers.
Sources: Macrobond, SSGA Economics, OECD as of 7 May 2018
All this begs the question: why have we not seen even tighter labour markets in the US and other advanced economies lead to persistent wage and price inflation? US inflation expectations have shifted upwards, but are still lower than they were four or five years ago.
From the fundamental side, one reason might be the increased use of automation. Our conversations with companies about the difficulties of finding workers see a consistent reference to technology-driven approaches to bridge labour gaps.
Many business leaders express astonishment at their ability to introduce automation so quickly and effectively in ways not thought possible several years ago.
Moreover, given the tightness of labour markets, the increased capital expenditures made by US companies will feed directly through to improvements in productivity growth, providing a natural cap on inflation.
We still believe at a certain point that labour shortages will begin to push wages higher, as we are beginning to see in select areas of the economy. But that will take time and does not, in our view, pose a risk to persistent inflation in the second half.
Structural changes
Taking a quantitative angle, research has looked at how inflation has changed in the US over the past 30 years and found that underlying components of inflation have structurally shifted.
When we look at both the pro-cyclical components of inflation that show an increase in prices when an economy approaches full employment, as well as the acyclical components that do not move in tandem with economic cycles, we find that both acyclical and pro-cyclical components have shifted lower over the past three decades.
In other words, structural changes have altered the traditional link between unemployment, wages and inflation so that reductions in unemployment have less of an impact on inflation than before and it is getting more difficult to move the dial on inflation.
But our view is that we need to understand these changes rather than rush to conclude that there is no relationship left.
Global view
Once again, energy prices can affect inflation in the short term – and the recent run-up in oil prices certainly skews inflation risks to the upside – but the flattening of the Phillips curve in many countries likely prevents a more persistent deterioration.
Globally, the only place with any risk of rising inflation is the US.
Key points
- Will inflation increase with a rebounding economy?
- Even tighter labour markets have had no effect on inflation
- Reductions in unemployment have had less of an impact on inflation
It is true that we are starting to see a little inflation in Japan, where regular scheduled pay has picked up. In fact, in Japan the government has gone directly to companies to stimulate wage growth through tax cuts for pay rises – similar to quantitative easing for compensation – but to us this is not the same as creating a genuine productive opportunity.
Slowly expanding immigration policies are also starting to create an impulse.
Back in time
Back to the US, only twice since the Second World War has unemployment fallen to its current rate of 3.8 per cent – for a few years in the late 1960s and for one month in 2000.
Arguably the lack of policy response in the 1960s was one cause of the following years of high inflation that needed a painful and drawn-out policy response to bring it back under control.
The experience of 2000 is even more chilling as it came along with an expanding technology bubble that, when it burst, caused the 2001 recession.
Notwithstanding disturbing historical comparisons, the opposing forces of fiscal stimulus and trade tensions will dominate the inflation discussion for the remainder of the year.
In the case of a trade war, would the Fed tighten more?
Surging tariffs would undoubtedly be an inflationary shock, but we would expect the Fed to look through this and not overtighten in reaction, both because tariffs would likely be transitory and also negative for growth.
That said, trade policy remains the wildcard for the global economy. Nothing we have seen so far counts as a macroeconomic event, but a long drawn-out trade conflict could present a more serious threat to inflation.
Altaf Kassam is EMEA head of strategy and research at SSgA Investment
