Earlier this year the Financial Times called the remarkable lack of inflation in the US “A fly in the Fed’s ointment”. Despite the current expansion entering its ninth year, producer confidence hitting a 15-year high in September and unemployment dropping to one of its lowest levels in over 50 years, this has not stopped core inflation from falling to 1.3% in August.One might be tempted to look for temporary factors that led to this drop, but it is hard to escape the impression that this so-called ‘lowflation’ is anything more than just a temporary phenomenon, or one that is limited to the US. Given the inflation distribution in developed economies over the past 20 years, it is clear that the trend of ever-declining inflation rates has been going on for quite some time now.
There are many factors at play that explain this downward trend. Everything from de-unionization to greater efficiency (due to Big Data), from improved transparency (Amazon, the Internet) to globalization, and from digitization to aging populations, have all been mentioned as causes of this worldwide phenomenon. Added to this is the anchoring effect of the inflation expectations themselves: just as higher inflation expectations can lead to higher wage demands and, in turn, higher inflation, the same also applies to the downside.
It is this latter effect that explains the ECB’s current tenacity in its decision to continue pursuing an (overly) accommodative monetary policy: with inflation expected to be 2%, you can still push real interest rates to -2%, by cutting policy rates to 0%. That’s a lot harder to do if inflation is expected to drop to 0%. For this reason, economists like Paul Krugman and Olivier Blanchard are actually advocating raising inflation targets to 3% from the current 2% norm, in order to stay clear of the lowflation vortex.
This line of thinking is strongly opposed by another group of economists who believe that inflation will be structurally lower from now on, and that it is crucial that central banks adjust their policy accordingly. Ultra-loose monetary policy may not have led to regular inflation as defined by the CPI calculations, but it certainly did have some impact: it may have greatly destabilized asset price inflation. Over the past five years, many assets (housing, US equities, most bonds) have become expensive, which raises the odds of another boom-bust outcome. Central banks should therefore either pay less attention to traditional inflation, or even lower the inflation targets.
So where does this leave us? With two options. The first is that inflation is indeed a thing of the past, but as long as central banks refuse to recognize this, financial markets bubbles will be a permanent fixture. In this scenario, most assets may have become expensive already, but as long as central banks maintain the loose liquidity, there is no reason why they should not become even more expensive in 2018. This game will be a joyful one, right up until the next crash happens, that is.
The second option is that inflation is not dead. Declining commodity prices, disinflation linked to cheap labor in China, a drop in the natural unemployment rate: all of these factors have had an only temporary impact. In this scenario, wages are the main variable to keep an eye on, as they determine the fate of central banks and bonds, alike. Given the current benign inflation expectations, in this scenario, the bond markets appear to be the most vulnerable.
This article forms part of the Robeco 2018 outlook entitled Playing in Extra Time.
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