Why Lower Inflation Is Here to Stay
The anticipated uplift in inflation has largely failed to materialize even as the macroeconomic environment has shown considerable improvement. Our research takes a closer look at the traditional drivers of inflation, and considers whether the key relationship between low unemployment and rising inflation has broken down and what kind of long-term investment strategy may be appropriate in such conditions.
Since the Global Financial Crisis, GDP growth, equity prices and consumer confidence have all gone up. Inflation, however, seems to have stalled. It has picked up recently but many believe this to be temporary. Usually, when unemployment falls to low levels, as it has recently, wage inflation emerges – a relationship described by the Philips curve. But this time the curve is flat and there are no signs of entrenched wage inflation, despite record employment.
This inflation conundrum has been puzzling central bankers and financial practitioners for some time. Many theories have been put forward to explain why inflation is not rising as much as expected. Some believe that all the unemployed are not being captured in the data; this argument posits that many people left the labor force following the financial crisis and have yet to be persuaded to return. Moreover, changing demographics mean that labor force participation generally is lower and the natural rate of unemployment has fallen. These structural unemployment shifts are not fully reflected in cyclical unemployment data. The impact of automation, online retail and the lower costs of data have also been deflationary – there is a much greater degree of price discovery in the marketplace so consumers can shop around like never before. Finally, productivity growth is starting to come through after a lag on capital investment.
Deconstructing the Key Components of Inflation
Our Fixed Income Quantitative Research team has taken a structural approach to the debate, analyzing the underlying components of inflation, based on the Core Personal Consumption Expenditures (CPCE) index – the key inflation measure used by the Federal Reserve. We have broken Core CPCE down into 16 components and then divided these into two categories: pro-cyclical and acyclical. Pro-cyclical components of inflation move with the growth of the economy, e.g., house prices, while acyclical components do not, e.g., healthcare services and telecommunications.
In examining these two categories of inflation, we found that pro-cyclical elements have recovered to near previous levels (see Figure 1). Acyclical components, however, have been more volatile and failed to rebound to their average contribution of 65% of core PCE. Moreover, the acyclical proportion of inflation has been on a downward trend over the last 30 years. The most recent regime shift downwards came in 2008 when the global economy went into recession after the financial crisis.
Pro-cyclical components of inflation move with the growth of the economy, e.g., house prices, while acyclical components do not, e.g., healthcare services and telecommunications.
Figure 2 illustrates how pro-cyclical components have rebounded to their pre-2008 average, while acyclical components are still below their mean in both the current and previous cycles. We believe there are structural reasons why inflation may stay low or rise more slowly than it has in the past.
In order for inflation to take hold from here, both sets of components need to increase. If we look at the individual components of acyclical inflation in the US, we find the main reason that they have failed to recover is due to reductions in the cost of US healthcare services after changes to the Medicaid system. While healthcare services’ costs have recently gone up again, components such as finance, telecoms services, accommodation and non-durable costs have come down, weighing on overall acyclical inflation.
Other Factors at Play
Acyclical component trends may help us understand part of the current inflation story. However, there appear to be other factors at play. For example, broader structural changes in the global economy seem to be having more complex effects on inflation, altering the traditional links between inflation and unemployment and helping to explain why the Phillips curve is flatter than before.
In order for inflation to rise significantly from here, each element of what constitutes inflation has to play a part. If we posit a simple econometric model of inflation drivers, we find that it consists of:
- Lagged inflation – i.e., previous inflation can have some persistence
- Inflation expectations (e.g., if a person believes inflation will rise in future, they may ask for a pay rise today, leading to higher current inflation)
- Cyclical unemployment – i.e., the Phillips curve effect
- Imported input inflation – via globalization and affected by trade disputes
- Transitory shocks – such as oil price jumps or a sudden fall in supply side prices
The model in Figure 3 offers an intuitive way to think about inflation. It shows that the current flatness of the Philips curve is just one part of the inflation picture and we need to look at this in a comprehensive way. So we evaluated the influence of these inflation contributors and found that today’s inflation is driven far more by inflation expectations than by cyclical unemployment rates. Successful inflation-targeting by central banks in developed and developing economies over the last three decades has dramatically reduced inflation expectations and these remain well-anchored, as illustrated in Figure 4. As a result, we would expect inflation to remain low in the future.
Absent any systemic shocks such as sustained global trade wars, we could be in a new regime of lower inflation and hence should calibrate expectations to lower levels.
Drivers of Inflation Muted
Broadly speaking, inflation is well contained in most of the Western world. In Europe, the European Central Bank is barely stalling the downtrend in inflation over recent years – a hangover from the European debt crisis that followed the financial crisis. In developed countries more generally, the bargaining power of workers has weakened and the natural rate of unemployment has come down as baby boomers have begun to retire and more people have stopped looking for work.
Moreover, the sensitivity of changes in the unemployment gap to changes in cyclical unemployment everywhere has lessened, resulting in a flatter Phillips curve globally. This indicates there are likely structural changes at play that have altered the traditional link between unemployment, wages and inflation so that it is more difficult than before for reductions in unemployment to move the dial on inflation. However, we may need to work harder to understand these changes rather than rush to conclude that there is no relationship left. For example, when the cycle turns, we could see greater sensitivity between higher inflation and higher unemployment, with an asymmetrically more responsive Phillips curve than when growth was strong and unemployment low.
For the present, however, the reasons behind the flatter Phillips curve and the increased role of inflation expectations in determining future inflation have implications for secular unemployment and the globalization of the workforce. Absent any systemic shocks such as sustained global trade wars, we could be in a new regime of lower inflation and hence should calibrate expectations to lower levels. This has implications for asset allocation: if inflation expectations are anchored at a lower level, one would expect interest rates to be lower than in the past. Such an outcome would favor being long duration.
Prospects for Higher Inflation Appear Limited
We are moving toward a regime of slightly higher inflation, with some hourly wage rises, higher commodity prices and tariff-induced increases in specific areas. While oil prices may remain elevated for the remainder of the year amid supply constraints, as yet, there is no sign that wage inflation is taking hold or that the global economy beyond the US has reached a peak. In the US labor market, the incentives to quit are at their highest since 2001. But less than 2.1% of the labor force changes jobs each month, so it will take time for higher wages to filter through. Lower wage inflation combined with higher commodity inflation is likely to impact risk premia for commodity-importing countries as well as consumer sectors.
While the US-China trade dispute remains a serious concern, the trade tariffs imposed so far do not count as a serious macroeconomic event that might necessitate revisions of either global GDP or inflation forecasts, though the confidence intervals around these estimates has widened. In the meantime, the acyclical components of inflation would need to see a significant uplift to return to their past level of contribution to overall inflation. Until such time, it is difficult to move away from being long duration in both asset allocation as well as fixed income barbell strategies.