Inflation in the Twenty-First Century
The battle ain't over yet
My kids complain that I regularly disagree with prevailing beliefs “just to pretend you’re different”. My wife describes her annoyance at this habit in more colorful language.
If any of them cared about the Fed’s inflation target they wouldn’t be surprised that - just as inflation is falling back toward 2% (see chart below) - I think the battle is far from over.
This time I’ve got good company. Stephen King, HSBC’s Senior Economic Adviser, has just published a wonderfully written book called We Need To Talk About Inflation. He believes that the long-term risk of inflation remains under appreciated, basing his arguments around four intuitive inflation ‘tests’.
There is much more to King’s book than these tests. He does a great job explaining why inflation serves as a stealth tax hitting society in uneven and unfair ways. He also reminds us that central bank independence is relatively new and fragile. Governments and central banks are irresistibly pulled back toward each other over time, a process he calls the Burton-Taylor effect after the twice married (Liz thought it would be thrice) Hollywood couple.
Listen to our conversation on Top Traders Unplugged and read on to see where we stand now on his tests.
Test 1: Have their been institutional changes that lead to an inflationary bias?
Answer: Yes.
Since central bank independence is relatively new, it’s jealously guarded. That’s sensible, but has the side effect of causing central bankers to stay mostly quiet about the inflationary effects of large government deficits. This matters a lot because deficits are set to grow much larger in the coming decade.
Next is the Fed’s 2020 change to targeting an average inflation rate of 2%, rather than viewing 2% as an upper limit. In our conversation King said this “required a pre-commitment not to raise interest rates in the event that inflation were to move above target” because some inflation above 2% was necessary to offset the below 2% inflation we had previously experienced. Thus the Fed felt unable to move quickly when inflation started to rise and now faces a longer struggle to bring it down.
Finally there is quantitative easing (QE), which the Fed introduced during the GFC. QE means bond yields are no longer freely determined in the market. In the Carvilleian days of yore1 rising bond yields provided a signal to central banks that inflation concerns were growing. King likens QE to “dismantling the inflation early warning system”, again increasing the chances they will be slow to react to inflation pressures.
Test 2: Are their signs of monetary excess?
Answer: Maybe.
The graph below shows the value and change in US bank deposits and money market holdings - a measure of money supply known as M2. Money supply skyrocketed during the pandemic and remains 8% above its pre-Covid trend. In King’s mind that stock of extra money continues to be potential inflationary kindling.
But look at the graph on the right. That shows M2 falling at annual rate of 5%, a development my Rise Of Carry co-author Tim Lee calls “unprecedented in recent monetary history”. In a post following SVB’s demise I wrote about why Tim thinks this may actually cause a deflationary shock in the near-term.
Test 3: Is Inflation Risk Being Trivialized?
Answer: Trivialized is a bit strong, but under-appreciated? For sure.
My favorite graph in King’s book shows the actual UK inflation rate along with the Bank of England’s expected inflation in two years’ time. I’ve reproduced a version of it below, adding some newer data points.
In November 2020 UK inflation was almost zero and the BoE was expecting it to rise to 2% in two years’ time. In fact, by November 2022 inflation had jumped to 11%. What inflation rate was the BoE expecting two years after that? Still about 2%.
Despite a massive change in conditions and a very large forecast error, the BoE never changed its medium-term inflation forecasts, always remaining confident in its ability to bring inflation down. King sees this as evidence of over confidence. By the way it’s not just a British thing - the same pattern emerges if you look at the Fed’s inflation forecasts2.
Test 4: Have supply-side conditions changed for the worse?
Answer: Yes.
This is the least controversial test. Sure, things have improved since the worst period of global trade disruption. But looking out longer-term there are (at least) three major structural inflationary trends:
Demographics. Populations are ageing faster than pretty much anyone predicted. That pushes prices higher because retirees buy goods and services but don’t supply them. Therefore, as the older, non-working portion of the population gets larger, inflation pressure grows. Want to learn more about this? Listen to my conversation with Manoj Pradhan, co-author of The Great Demographic Reversal.
(De)Globalization. Wages were held in check for decades by the integration of China, Vietnam and Eastern Europe into the global labor force. That’s over. Worse (from an inflation perspective at least) it’s going to partially reverse, putting upward pressure on labor costs as the ability to outsource to cheaper foreign locations is constrained. Just yesterday the FT’s Unhedged column quoted Don Rissmiller of Strategas: “We are running the US economy at a pace that requires 171 million workers, when we only have 167 million available in the labour force.”
Energy Transition. Transitioning to renewables adds to inflationary pressure because fossil fuel and its supporting infrastructure is still a cheaper way to deliver energy.
King’s tests are important and intuitive starting points for understanding inflation risk. In the coming days I’ll add to this by explaining how the unintended consequences of fighting deflation over the last few decades makes fighting inflation now more challenging.
And…for you optimists…the next Ideas Lab podcast will feature technology expert Mark Mills who thinks I’m wrong. Inflation, he believes, is about to be solved by a burst in productivity created by a convergence of advances in information, machines and materials.
If you’re under 40 please see: bond market vigilantes.
For statistics nerds these results are not driven by the use of the median. The maximum inflation forecast also varies very little with the actual inflation rate. In other words, even the most pessimistic Fed board member almost always expects inflation to get close to the 2% target in two years’ time.