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Inflation is not dead, it’s just shifted direction

Inflation is not dead, it’s just shifted direction

07-09-2017 | Monthly outlook

Inflation can never be eradicated and so central banks will pursue targets for it, even as prices fall, says Lukas Daalder

  • Lukas Daalder
    Lukas
    Daalder
    Former CIO Robeco Investment Solutions. Daalder left Robeco in July 2018.

Speed read

  • Main central banks have an inflation target of around 2%
  • Structural changes have consistently lowered prices
  • Inflation has moved into assets from goods and services
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Some economists argue that persistent disinflation – and the greater threat of deflation – means central banks should either abandon their common 2% target or replace it with a lower one. It follows a growing belief that monetary policy led by quantitative easing has been ineffective in creating inflation to drive economic growth.

But this is not necessarily the way to go, says Daalder, Chief Investment Officer of Robeco Investment Solutions. He says inflation is still around, though it is now seen in the prices of financial assets rather than the more traditional goods and services.

Central banks seem likely to stick to 2% as their inflation target, even though it is not based on academic research as being optimal, but was in fact arbitrarily chosen by New Zealand in 1989. The European Central Bank, US Federal Reserve, Bank of Japan and Bank of England all continue to target 2%, even though inflation in their respective jurisdictions has consistently been below that for most of the past decade.

The structural decline in inflation seems hard to miss. Source: Robeco

Why inflation has fallen

Daalder says there are many arguments as to why the threat of inflation – which decades ago was in double digits and destabilized entire economies – has so dramatically lowered in the modern age. One is digitalization, which has revolutionized industries such as the media, photography and music and made it possible to produce extra copies of news items, games or songs at virtually zero cost.

Another is the loss of the market power of labor, following the demise of unions, globalization and the ongoing automation of formerly labor-intensive industries. Aging populations are also deflationary, since older people tend to save more and spend less. Meanwhile, oil has lost its power to move markets as other forms of energy such as shale gas and solar power have steadily weakened the oil price.

“All of these arguments point in the direction that inflation has been structurally lowered, a theory which is also supported by the inflation data we have seen in recent years,” says Daalder. “This raises the question of what happens if central banks continue to aim for an inflation rate of around 2%, while the mechanics of the modern-day economy prevent it from ever reaching that.”

A ‘monetary phenomenon’

“The economist Milton Friedman once said: ‘Inflation is a monetary phenomenon. It is made by or stopped by the central bank.’ In that case, why have the central banks been unsuccessful in reaching the 2% target? Normally, an increase in liquidity would have resulted in ‘too much money chasing too few goods’, to once again quote Friedman, leading to inflation. Why hasn’t this inflation materialized?”

“The answer is that this inflation has in fact materialized, but not in the sphere of goods and services, but rather in the realm of financial markets. The strong rebound seen in real estate markets; the fact that the S&P 500 is trading at a Shiller PE of 30.3x; and abnormally low bond yields (which means high bond prices) can all be seen as a reflection of inflated financial asset prices. As these assets are not included in the inflation target of central banks, we do not see them as inflationary, though.”

Alternative views

Daalder says a different group of economists accept these arguments for why disinflation has occurred, but prefer to focus on the risks involved with the decline in inflation, and future expectations for it, and deal with that instead. They primarily cite the loss of effectiveness of monetary policy in being able to create inflation, using the interest rate as the main weapon, as an indication that other methods are necessary.

They also argue that wages are traditionally sticky to the downside, where it is easier to fire people than adjust wages lower, potentially harming the economy. And letting inflation drift lower means the real level of debt steadily rises over time (assuming interest rates stay the same); someone taking out a 30-year mortgage assuming a 2% inflation rate would face a higher debt burden if inflation structurally drifts lower.

“Looking at the statements of various central banks officials, it appears that most of them can be considered to be in the second camp,” says Daalder. “This seems to point in the direction of the boom-bust scenario: central banks pushing too much liquidity in the system creates ‘inflation’ in all of the wrong places.”

“There is a more positive scenario possible as well, though: the scenario in which ordinary inflation will return, albeit it with a delay. “We are somewhat reluctant to embrace the ‘inflation is dead’ line of thinking,” says Daalder. “This is partly because we have seen these claims more often in the past – they remind us a bit too much of the ‘the business cycle is dead’ claim that resurfaces every ten years or so – but partly also because we do not believe that inflation can ever be eradicated.”

“As long as supply and demand do not perfectly match, inflation will remain part of our system. We can particularly see tightness returning in labor markets, with demand outstripping supply. Technological change may have postponed wage increases, but we do not see why it will not come eventually. In this scenario – our base case – inflation will return after some delay, and with it bond yields are expected to rise as well.”

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