This is Linchpin’s ninth annual update on the long-term outlook for inflation, in which we monitor a range of inflation indicators. Last year we could see the seeds of higher inflation in the longer term but expected western growth to remain very low and inflation to stay in the 0-2% range. We thought the main question was whether it would follow a Japanese deflationary or a British stagflationary model. Since then COVID-19 has blown in, precipitating the largest recession for decades but also the biggest monetary and fiscal response ever. This year we expect more inflation pressures on the high street but, while it will inevitably come, we still do not see a sustained rise in inflation quite yet.
William Bourne
Principal, Linchpin Advisory Limited 31st December 2020
LINCHPIN INFLATION INDICATORS
What a year! 12 months ago we were in the camp of very low growth. We could see increasing fiscal and monetary laxity leading to a debasement of fiat currencies and inflation eventually, but we could also see some powerful deflationary trends such as technology in place. We therefore thought a sustained rise in inflation was a few years away. One year later, COVID-19, or more accurately the response most developed countries have made, has put both those trends on full speed ahead. On balance, our overall view has not changed but there are many more nuances.
First, we review our 13 indicators. Three, commodity prices, liquidity creation and over-capacity have moved in an inflationary direction and one, the output gap, in a negative one. Consequently there are seven pointing to inflation, two neutral and four to deflation, or a net score of +3 compared to +1 a year ago (and -8 five years ago).
In the past 12 months we have seen a global recession on an unprecedented scale and an equally large fiscal and monetary response. Interest rates have now been close to zero in most G7 countries for over eleven years. Headline inflation numbers so far have stayed well below 1% but beneath that there are large divergences. Digital and online solutions have forged ahead and pricing in specific ‘old’ industries, such as airlines, hotels and high street clothing, has for the most part collapsed. Food prices, especially in the Americas, have risen, and there are clear signs of pricing power being exploited in some ‘newer’ tech areas.
Compared to the aftermath of the Global Financial Crisis of 2008-9 the economic recovery, at least in data terms, has been much quicker. That may not be entirely obvious on the high street because so much more is being done online but it is there in terms of shipping volume and business confidence indicators. In contrast to the austerity of 2009 onwards fiscal policy is strongly expansive, while QE4, perhaps five times greater in impact than QEs 1 to 3 combined, has been directed at people’s pockets through initiatives such as furloughs.
That is a key reason why our supply-focused indicators have moved most. Official consumer and producer prices do not yet reflect this at (OECD data) around 1% and 0% respectively. This is partly down to the fall in oil prices during the first half of 2020 from US$60 to a low of below US$30 and partly that the data does not capture rapidly changing consumer habits. In contrast, the prices for most agricultural and many industrial commodities are around 15% to 20% higher than a year previously.
Combining this with the clear supply-side frictions in goods trade resulting from COVID, a ratcheting up of tariffs and other barriers between China and parts of the West, and BREXIT, we are of the view that we will see an increase in consumer inflation in 2021. The UK in particular is vulnerable to a blip because of the extra frictions which BREXIT and other tensions may load onto supply chains even without the introduction of tariffs.
However, we do not see this as necessarily the start of a sustained rise in inflation. Over the last nine years we have constantly pointed at technology, globalisation and the over-supply of labour as major deflationary forces. The last of these was beginning to fade last year as labour standards led to higher wage costs but the effect of the recession is likely to reinstate the deflationary trend. The first two are still in evidence, albeit perhaps their deflationary impact has weakened after COVID.
We would also point to the market indicators we follow. Bond markets fell sharply during the year and are firmly pointing to very low inflation for some time to come. Implied inflation rates five years forward suggest around 2% in the US and 3% in the UK. These may be distorted by the pressure on pension funds to buy inflation linked gilts even at a real yield of -2% or less. Without these pressures, implied inflation would be even lower.
We also note that, following the collapse of demand, the output gap reached a record low (eg. 10% in the US) and our indicator has therefore moved back to deflation. We do not place too much weight on this, as we suspect the data is capturing more of the ‘old’ than the ‘new’ economy.
Current market rates
Annual consumer price inflation for the OECD stands at 1.2%, with much of Europe and Japan being close to zero. Food inflation is appreciably higher, especially in the US where it stands at about 4% currently. Producer price inflation fell sharply in the first half of 2020 and has not made much recovery since. It now stands at 0.2% for the OECD countries.
Conclusion
Our broad picture of future inflation has not changed greatly. We are even more certain after 2020 that the policies currently in place mean that inflation is inevitable in the long-term. Government borrowing can only realistically be reduced by inflation. It may be that some governments are willing to run with much higher levels of public debt, as Japan has for many years, but they are vulnerable to an increase in interest rates and we do not believe many will choose to do so over long periods.
Our indicators suggest that there will be a short-term rise in consumer inflation in 2021 caused mainly by supply side shortages and frictions. Food prices may be particularly impacted. An increased willingness to spend on the (metaphorical) high street after the lockdowns of 2020 may modestly add to the demand side pressures as well. We are not confident that the official data will pick up inflationary pressures in services and believe they may well understate reality.
However, we doubt that this is the start of a new inflation cycle. That is because the deflationary trends we have previously noted remain in place and our market indicators are firmly pointing towards low inflation. In our view a necessary condition for a new cycle to begin which is not yet satisfied is much greater demand from consumers. As the effects of fiscal easing begin to kick in that will happen, but the timing is a few years away and will probably first be seen in a significant rise in bond yields. As last year, we are watching those more closely than any other single indicator.
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