Economists’ year-ahead articles customarily center on forecasts for economic activity. Monetary and fiscal policy, geopolitics, inflation or, in the case of this year, trends in the spread of Covid-19, are popular topics. But typically they are filtered through the prism of what they imply for, or how they are affected by, the outlook for growth.
This year we are subverting the convention by focusing on the outlook for inflation. Why? Well, other than following the adage of variety being the spice of life, there is the question of whether the Covid-19 pandemic will be the crisis that finally reverses the decades-long trend toward ever-lower global inflation. This topic has come to dominate the investment zeitgeist over recent months, as it has done periodically over these decades.
Current trends are disinflationary
At first glance, it may seem an odd time to be worried about the future of inflation. According to the Dallas Federal Reserve, global core inflation (excluding the U.S.) fell to 1.6% in September. This is only a fraction above its lowest rate since their calculations began in 1982. Moreover, this downward trend has been very broadly based — aggregate core inflation in both emerging markets (EMs) and the advanced economies, or developed markets (DMs), is currently sitting at multi-decade lows.
Concern about meaningfully higher inflation also seems strange within the context of the present macroeconomic environment. We are the first to acknowledge how hard it is to measure precisely the potential output or the natural rate of unemployment. Yet, there is little doubt that there is currently a large shortfall in aggregate demand across the global economy, as well as considerable spare capacity in most labor markets. And, even with a comparatively flat Phillips Curve in most countries, that spare capacity is set to put downward pressure on labor-cost growth and underlying inflation for years to come. That is, unless the global economy recovers much faster than we anticipate.
But low inflation expectations are also entrenched in asset prices
Examined through a different lens, the inflation question makes much more sense. For, as much as the reality of ultra-low current inflation is obvious, it is also priced into assets for as far as the eye can see. Market-implied inflation expectations for the second half of this decade in the U.S. are just 1.8%. That’s 0.5% lower than would be consistent with the U.S. Federal Reserve (Fed) meeting its long-term inflation objectives.
Moreover, the gap is even larger when considered in terms of the Fed’s new commitment to allow inflation to modestly overshoot the target to make up for an extended period of below-target inflation. Meanwhile, these wedges between current inflation targets and market-implied inflation expectations are even larger in Europe and Japan.
The risk, then, is obvious. If inflation were to spring back rapidly, significantly and persistently, a wholesale repricing of government bonds would ensue. And, depending on the drivers of any change in inflation dynamics, the pricing of risk assets would need to adjust as well.
The conceptual foundations for our inflation views
When thinking about the likelihood of a meaningful change in long-term inflation dynamics, it is helpful to draw on a clear conceptual framework grounded on robust empirical evidence. Our survey of the long literature on the determinants of inflation and, in particular, the factors that herald changes in inflation regimes or paradigms, yields the following three jointly necessary and sufficient conditions:
- A fragile anchor for prices, such that the inflation expectations built into wage and price setting are able to adjust quickly in the face of changing economic conditions and policy frameworks.
- A sustained period in which the economy is operating a long way above (below) its potential, such that the prolonged excess (shortfall) in demand persistently feeds through into higher (lower) wage and price growth.
- A structural change in monetary policy frameworks — including the independence of central government from political interference - such that changes in inflation dynamics caused by conditions (1) and (2) are facilitated by or accommodated within central bank reaction functions.
The careful reader will note that our three criteria make no mention of growth in the money supply, or the size of government debt or deficits, or structural forces like globalization, technological change, labor and product market regulations or demographics. This is not because these factors don’t influence consumer prices — they most certainly do. But they only matter for long-term inflation dynamics and regimes to the extent that they influence or are influenced by our three core criteria.
No systematic correlation been money growth and inflation
Source: BLS, FRB/Haver/Aberdeen Standard Investments, December 11, 2020.
Drawing the right lessons from the 1970s
Some historical examples serve to illustrate the point. The 1970s was the last decade that the global economy endured a large, persistent and damaging increase in underlying inflation. And, if we survey the decade, we do see that the supply side of economies was generally weak. This was because of the oil price shock, sluggish technological change, modest rates of globalization and sclerotic labor and product market regulations in many countries. Growth in the money supply was also strong and fiscal indiscipline commonplace.
Office for Economic Cooperation and Development (OECD), March 2020.
But, while those factors were tailwinds for inflation, they could not have led to the realized surge in inflation without inflation expectations already having become gradually less well-anchored through the 1960s. In addition, central banks subsequently behaved as though there was a long-run trade-off between unemployment and inflation. As a result, the inflation threat was not taken seriously until it was eventually beaten down by very tight monetary policy during the 1980s.
But also the antecedents of Japanese deflation
The record of Japan since its asset bubble burst in 1991 is also salutary. Yes, the end of the economic, credit and financial boom was disinflationary. Yes, deteriorating demographics were another headwind for demand. But the key reason for Japan’s descent into deflation and subsequent struggles to escape it primarily relate to policy choices. The Bank of Japan (BoJ) kept monetary policy far too tight in the decade after the crisis. Japan’s over-levered banks were not recapitalized quickly enough, further reinforcing the demand shortfall. And, despite steadily rising public debt, fiscal policy was not sufficiently focused on supporting growth once policy rates were at their effective lower bound.
In fact, despite the massive expansion of the BoJ’s balance sheet since 2013 and sustenance of large budget deficits, monetary and fiscal policy have not been jointly expansive enough, or reactive enough to growth and inflation disappointments over recent years, to generate more than a modest increase in underlying inflation. Indeed, anyone wanting to argue that the combination of rapid growth in central bank assets, large budget deficits and high public debt set the scene for much higher inflation must confront the reality of Japan. They must ask what is fundamentally different in Europe, the U.S. or other advanced economies.
Back to the new normal the most likely scenario
What does this all mean for our own long-term outlook for global inflation? Well, let’s again apply our three criteria. Inflation expectations remain extremely well-anchored. If there are any signs of unanchoring, the momentum is down rather than up. Turning to output gaps, we expect the global economy to be operating below its potential until at least the end of 2023. This will push any possible period of excess demand a long way into the future.
Sure, globalization has turned from an inflationary headwind to a tailwind over recent years. And the era of product and labor market deregulation appears to be drawing to a close. However, these shifts have been modest so far and we believe are more than offset by the pandemic’s weight on demand. Meanwhile, disinflationary digital technological changes continue unabated, while the global population is still ageing.
Decades of globalization will not be swift or easy to unwind
Source: The World Bank, 2018
But what about policy? Surely the extraordinary fiscal support provided through the crisis, coupled with aggressive loosening of conventional and unconventional monetary policy pushes in the other direction? We do agree that the nature of policy support can help to limit disinflationary risks. And in an ideal world would have become even more radical – for example by more seriously considering the potential advantages of "helicopter money." But at present the support is no more than is needed just to begin the process of closing the output gap. Indeed, there are doubts in many countries about the staying power of fiscal support in particular.
It’s also true that growth in the money supply has been strong so far this year. But that is simply the corollary of joint monetary and fiscal easing — loans and stimulus to the private sector show up as deposits in the banking system. The big drop in the velocity of money is a better signal of the true state of demand. And, for all the apparent aggressiveness of central bank action, reviews of central bank frameworks — including the Fed’s — have been pretty timid so far. We therefore continue to have conviction in our base case for underlying inflation to remain, on average, at or below central bank targets in most countries over the next decade.
But the tails of the long-term inflation distribution have fattened
Of course, when thinking about the future and how to price assets, we can’t just think about our base case. We also have to think about alternative futures and the distribution of risks around our baseline. Here we do agree that the current political, economic and market constellation is more fragile than in the past. This could lead to more significant, political economy-driven changes in policy and hence inflation and return regimes.
As such, the end game of our era of more populist politics and large nominal debt burdens could give way to a period of fiscal dominance. Central banks would lose their effective independence and fiscal decisions would drive monetary outcomes that are inconsistent with long-term price stability. These are the arguments that inform many investment discussions at the moment, and they are plausible ones.
However, we take issue with the view of many economic and market analysts that the risks to the current paradigm predominantly lie to the upside. It is equally plausible to us that, in the face of persistently weak demand and the constraints of existing policy frameworks, central banks and governments come to accept that much lower inflation is here to stay. Indeed, the outcome of the U.S. election has produced a Democratic president in Joe Biden but a Congress split between a Democratic House majority and a Republican Senate majority. This has reduced the likelihood of much-needed additional large-scale fiscal stimulus and thus rendered disinflationary scenarios more probable.
The upshot of our analysis can best be framed in terms of an indicative long-term inflation probability distribution. Relative to the pre-Covid-19 distribution, the central tendency of our outlook has shifted modestly lower. However, the fragilities of the current environment imply that both tails of the distribution curve have become fatter. There will no doubt be inflation prints over the next year that re-kindle the discussions around that right-hand tail. And, in a world in which assets are not really priced as though it has become fatter, our views imply that there may be benefits in seeking selective inflation protection, particularly in those markets where there is a greater chance of reflationary economic and policy outcomes. But it would not be wise to put all of one’s eggs in the inflationary basket given the very real risk that the crisis could also be the gateway to a more complete "Japanization" of the global economy.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.