January 7, 2020
Gary Schlossberg, Global Market Strategist
Inflation—the Economy’s “Dog that Didn’t Bark”
- We believe that deep-seated structural changes are as responsible for stubbornly low U.S. and global inflation as moderate growth and other short-term, cyclical forces.
- We also believe that structural and cyclical headwinds to inflation are slowly eroding enough to support inflation’s modest rise, bringing an end to decades-long “disinflation.”1
What It May Mean for Investors
- Even modestly higher inflation or gradual interest-rate increases (should rate increases unexpectedly occur) risk creating headwinds to a seemingly ageless U.S. economic growth cycle and an historic financial-asset rally. We believe that these positive developments stem partly from historically low interest rates and their effect on the economy’s interest sensitivity and asset valuations.
We believe inflation’s refusal to obey conventional economic wisdom by moving higher in a maturing growth cycle has been among the great economic mysteries over the past decade—as it has remained stuck below central-bank targets in the U.S. and abroad—despite policy makers’ generous cash injections into financial markets. The biggest surprise to us has been in the U.S., where an unemployment rate at a 50-year low has not been enough to move wage or price inflation back to precrisis levels. Stubbornly low inflation has been of more than passing interest to investors as many have benefited from the price lift to stocks, bonds, and other assets that resulted from historically low interest rates by central bankers who were determined to re-inflate their local economies.
More structural than cyclical
What gives? We believe that cyclical, or short-term, developments are partly to blame. The same moderate growth behind this expansion’s record longevity has lessened the threat of bottlenecks normally exposing the economy to price pressures during the expansion’s middle and late stages. Dollar strength—combined with economic sluggishness in Europe, Japan, and (more recently) China—has kept a lid on domestic prices abroad and on U.S. import costs tied to driving trade-sensitive “goods” prices in the Consumer Price Index (CPI).
But we believe there’s more to the extended bout of “disinflation” (a declining inflation pace) than the short-term, more temporary changes tied to the business cycle. For starters, inflation has been in secular decline since peaking (at a level above 14.5% in the U.S.) in the early 1980s—reflecting the tailwind created by structural, or more enduring, forces. In the U.S., Federal Reserve (Fed) Chairman Paul Volcker’s determination to break the back of inflation with extraordinary monetary tightening—and the deep recession that followed it—was a key catalyst for inflation’s extended declines here and abroad (through the dollar’s central role as a transaction currency in world trade and finance and its effect on global inflation and interest rates).
Beyond that is a laundry list of profound economic changes that coincided with (and resulted partly from) the shock to inflation more than 35 years ago. Several helped to reverse so-called “institutional rigidities” that contributed to the “great inflation” of the mid-1960s, 1970s, and early 1980s. Among the most visible was “globalization” in a more fully integrated world economy—led, eventually, by China—exposing established players to an array of low-cost producers. Equally visible was the push toward deregulation, paced by the economies of the U.S., U.K., Canada, and elsewhere, combined with the growing importance of less capital-intensive technology and services industries adding to competition by lowering entry barriers for new and innovative firms.
The growth and concentration of social media firms (and certain other technology firms) created an unexpected and added inflation headwind through a different model that relied more on hidden and less apparent costs in an effort to create value. Technological change extended to online shopping (via the so-called “Amazon effect”) and resulted in undercut prices of products offered by established, brick-and-mortar retailers. Feedback from the subdued inflation’s effect on business pricing power reinforced the trend. Companies’ efforts to maintain profit margins in a weak pricing environment encouraged sales of less costly, private-label goods and partly undercut wage growth as businesses sought to manage labor costs.
The more cautious spending patterns of a growing retiree cohort in an aging U.S. population also contributed to price restraint. At the other end of the spectrum, mounting student loan debt and lifestyle changes have tempered U.S. housing demand, and with it, housing-related expenditures that are a sizable share of the CPI. Measurement issues affecting the CPI also have weighed on U.S. inflation, most notably quality adjustments to standard consumer goods like computers, smartphones, and other “high tech” equipment that lowered the measured price of these goods in the CPI.
When these forces are combined, the pressure still may be modest enough to keep inflation well within its long-term norm. In a more leveraged, interest-rate-sensitive economy, with increasingly elevated stock, bond, and other asset values, however, the increases could be viewed as a yellow flag, meriting some caution for those on Wall Street and Main Street.
1 Disinflation is a short-term slowing of the pace of price inflation.
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Consumer Price Index (CPI) produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. An index is unmanaged and not available for direct investment.
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