“It was obvious that he was a man who marched through life to the rhythms of some drum I would never hear.” – Hunter S. Thompson, Hell’s Angels: A Strange and Terrible Saga
Trump and inflation
The US election prompted many in the market to dramatically reassess their inflation expectations. Large chunks of President Trump’s legislative agenda were deemed inflationary – from the renegotiation of NAFTA to the proposed infrastructure package – sending many in the bond market running scared. Since then, a lull in inflation combined with this US administration’s agenda running into the congressional sludge has prompted a rethink. Is Goldilocks here to stay?
There are many arguing that inflation will be durably lower for a range of reasons. Global trade, the advent and spread of the internet, and wider technological advances are the three that we will tackle here.
That global trade has brought down prices around the world is intuitive. Increasingly available cheap imports from less developed economies with competitive labour forces have not only allowed developed world consumers to buy cheaper goods and services, but the extra competition has also forced developed world producer prices down over time. The fact that import price inflation tended to be systematically lower than actual CPI inflation during the 1990s in particular, a period of rapid growth in global trade, may hint at these effects.
The Internet has also surely exerted downward pressure on prices, as, similar to the global trade story, lower cost producers have given customers cheaper alternatives whilst also forcing the surviving offline competition to adapt. However, the most pronounced effects may well be in the past. Recent research by Alberto Cavallo – one of the architects of the Billion Prices Project – found that online and offline prices are now identical about 70% of the time in the US and almost always in the other developed economies examined (Cavallo, Are Online and Offline prices similar? Evidence from Large Multi- Channel Retailers).
Technological advances have also surely contributed to this era of low inflation. The growth of the sharing economy is just one of the areas cited by those puzzled at the low levels of measured productivity in this current cycle. There may well be some degree of mis-measurement; the statistical framework we use to measure the modern economy was, after all, designed to capture post-war production – the steel and wheat economy, not an economy where many of the services we receive, we now get for free. However, there has always been a degree of mis-measurement, as persuasively argued by Nordhaus in his study on the price of lighting over the centuries. Here, the difficult question is whether this mis-measurement is larger today, since the service sector (whose production is inherently harder to measure) has come to play a larger role in developed economies.
While there is little remaining empirical evidence to suggest that structural forces are keeping inflation low, there are some one-off factors helping to cyclically depress prices in the US in particular – one such area is the much-talked-about step change in the competitive backdrop within US mobile phones, which in itself is likely to continue to exert a drag on overall price pressures until the first quarter of next year. More broadly, with the prospects for healthcare and shelter inflation looking moderate, it seems wise to expect prices to trend unevenly higher rather than soar.
Similarly, wages, which generally sit at the nexus of inflationary pressures, should continue to trend unevenly upwards. History tells us nonetheless that the relationship between growth and wages is a loose one, prone to defying the texbooks. Furthermore, compositional factors likely explain much of the slower than expected trajectory so far in this economic cycle – the unemployment axe fell hardest on the lowest income segments in the Great Financial Crisis and their gradual re-entry into the labour market has kept aggregate wages low on the measures that fail to adjust for this compositional effect.
Putting this all together, we see the forces of inflation slowly gathering in coming years, amidst diminishing economic slack. If this US administration can figure out how to work productively with Congress, then there are certainly upside risks to that benign forecast. However, that remains a big “if”. Nonetheless, even moderate inflationary pressure is likely sufficient to allow the various central banks in the developed world to slowly but surely remove their patients from the monetary intensive care unit. As we’ve said before, it is time for monetary policy to begin to reflect the fact that the global private sector’s attitude to risk seems finally to have normalized after a long and understandable hiatus.