Annual inflation/deflation briefing
This is our eighth annual update on the long-term outlook for inflation, in which we monitor a range of inflation indicators. Last year we wrote just before the Federal Reserve’s surprise cut in US rates in January. We could see the seeds of inflation sown quite clearly but, against what we saw as an overly tight monetary policy, our inflation needle moved back towards disinflation. This year it is almost consensus to assume that much of the West is going into a period of very low growth, and the only question is whether it will follow a Japanese deflationary or a British stagflationary model.
When we wrote a year ago, we said that monetary policy was too tight and, if continued, would lead to a recession. Federal Reserve Governor Powell still threatened further interest rate rises which, despite the end of austerity and the inevitability of higher inflation in the long term, was sufficient for us to conclude that inflation would stay low for another year.
A year later there has been a sharp change in monetary policy, with three cuts in US rates and the clear commencement of QE4 at least in America, Europe and Japan. Politicians have also thrown the fiscal lever, as witnessed by the latest loosening by Abe in Japan and the promises made by UK election candidates.
Despite these policy shifts, inflation and inflation expectations continued to fall in 2019. OECD data at October 2019 shows G20 inflation almost 1% lower than 12 months earlier at 1.36%. The major outliers are China at 3.8%, and Japan and Korea at close to zero. The implied break-even US inflation rate ten years out has fallen by about 10bps to 1.7%, while the five year forward rate five years out has behaved similarly.
As we said last year, in the longer term the final abandonment of fiscal austerity by most developed countries is clearly inflationary. Not only does it build up government debt levels but, by adding to demand, it increases pressures in areas such as labour costs. It confirms our view that western fiat (ie. paper) money will ultimately be debased.
The question for investors is when. The output gap at the bottom of the Global Financial Crisis stood at over 4% (OECD data) but that had been eliminated by last year. We would not place too much weight on this but is a gentle indication that there is no longer a deficit of demand.
More important in our view is the likelihood that QE4 will be very different from previous periods of QE. In the 2009-2015 period additional money was largely used in technical ways to mop up bad debt and prevent the financial system seizing up. It did not find its way into the high street, though it did of course create price inflation in both financial and real assets. We think that QE4 will see more finding its way into the real economy, simply because that is where the political imperative is. Politicians don’t need to use helicopters or believe in a magic money tree to realise that their political careers depend on making better lives for those who didn’t benefit from asset price inflation. That means getting money into their pockets.
We commented last year that our ‘deleveraging’ indicator was really leveraging and we have now changed its name to reflect that. Fiscal and monetary easing makes it cheap to borrow, particularly when the ultimate lender is a government whose primary agenda is not about returns.
Against these pressures are strong disinflationary ones caused by technology. It’s noteworthy that both Japan and Korea, very different economies, have zero inflation despite tight labour markets and we don’t have to look very far to find plenty of evidence of technology cutting out layers of cost. We particularly like the comparison between a 1990s child playing with Lego and their 2020s offspring learning through Minecraft on their phone. In this one example we can see chemical and plastic factories, packaging, distribution services and retail toy shops all largely removed from the cost chain.
Also on the costs side, in 2018 the main feature in commodity prices was a 25% rise in the oil price. In 2019 there was no general impetus to inflation from commodities and gas prices were notably weak. Agricultural and base metal prices were broadly unchanged (data 12 months to end-November) though iron ore was +16%. Precious metals rose (gold +20%, silver +17%). Oil and oil-based chemical prices generally fell, though crude oil (-3%) held up much better than natural gas (-34%).
On the other hand, labour cost pressures are clearly inflationary. Many developed economies are close to full employment and for the UK BREXIT may add further frictions to employment. The US has chosen to use trade sanctions as a primary weapon in its economic policy, most notably against China. A substantial reverse in globalisation can only add to supply-side frictions and inflationary pressures.
If demand and supply factors, supported by policy, are broadly inflationary, the conundrum facing investors for the third year in a row is the fact that market indicators are facing in the other direction. Bond yields have fallen sharply during the year while implied inflation rates are modestly lower. For example, the ten-year US Treasury yield started the year at 2.66% and ended it at 1.90% after reaching a low of 1.47% in late August. Some may argue that yields are distorted and not a reliable measure, but we are wary of assuming that this time it is different.
In summary, while monetary and fiscal policy must lead to higher inflation eventually, our indicators suggest that we have not reached a tipping point yet. Five are pointing to inflation, four to deflation, and four are neutral. Three indicators (bond yields, commodities and overcapacity) have moved in a disinflationary direction, and two (gold price and liquidity creation) the other way.
Current market estimates of inflation
The IMF estimate for Advanced Economies’ inflation as measured by the deflator is unchanged from 12 months ago at 1.9% but the five years’ out forecast (ie. 2024) has fallen from 1.5% to 1.0%. Consumer price inflation (CPI) forecasts five years’ out are close to the OECD’s at 1.9%. The CPI forecast for Emerging Markets is higher but again little changed from the forecast 12 months ago at 4.2%. This may reflect the forecasting process but there is little sense that the number-crunchers expect inflation to take off over the next few years.
Conclusion
At Linchpin our base case remains (much) higher inflation in the longer term, primarily because of the levels of debt in the West and an increased level of political dysfunction. Since last year, policy has swung clearly in this direction but market indicators have gone the other way. Our conclusion is that inflation trends in 2020 are likely to be similar to 2019 - the subject of two opposing forces but resulting in low positive inflation in the 0% to 2% range. However, if this is all that can be achieved even with liberal policy support, without that the risk of a descent into Japan-style deflation would become significant. As this would have significant implications for investors, it is not the time to be too dogmatic about the future.
The historical record of the indicators we follow can be viewed here, or if you wish to discuss anything in this article with the author, please contact us on research@linchpin.uk.com