Inflation: Structurally Lower for Longer?
Will inflation reach the highs it did in the twentieth century, or might we expect a structurally lower rate? As the world focuses on the short term (or ‘cyclical’) swings in headline inflation, it is worth considering the long term perspective.
A Historical Perspective
In their report Mission Impossible: 2% Inflation, BCA look back to the 17th century to identify patterns of price changes over time, and what appears to be the case is that persistent inflation is the aberration, rather than the norm (see chart below). Indeed, the previous three hundred years spent as much time in a deflationary environment as an inflationary one.
[BCA Research; Mission Impossible: 2% Inflation]
It is worth, then, considering the reasons behind the inflationary period of c.1965-2007, and whether these are likely to be repeated or reversed.
The twentieth century saw two world wars, the Bretton Woods era and its fallout, the 1973 OPEC Oil Crisis, greater central bank independence and, perhaps most importantly, the onset of a credit boom in the western world. Indeed, the UK alone saw three distinct phases of inflation exceeding 4% (see below).
Another important consideration is the rise of the middle class. While this in itself led to inflationary forces (higher velocity of money, or “spending”), it has also created a structural shift in the power base. Politicians and central bankers must now more than ever respond to the masses, who will always take the easy option and vote against falling wages and house prices, preferring money printing, currency devaluation and fiscal spending in a way that did not happen in the nineteenth and early twentieth century. Put simply, today’s western democracies will simply not stand for the levels of deflation seen in the three hundred years to the early 1900s.
Thus, while some of the twentieth century inflationary pressure was clearly cyclical (oil crises, tax increases and the like), the expansion in credit, the demographic dividend and growth in the middle class was not, and it was these structural forces that led to the persistency of the inflationary environment.
So, what can we expect from the twenty first century? A realistic expectation is for some of these structural trends to reverse, putting pressure on any policy looking to generate inflation.
The central reason for this view is that the credit boom that accompanied the 1965-2007 period is now in its deleveraging stage, putting downward pressure on prices as households, companies and sovereigns spend more money on paying down debts than consumption and investment. Another reason is that technological progress continues abound, which is also disinflationary as new, cheaper goods and services come to market, and capital efficiency is improved. Finally, the demographic dividend mentioned above has become a burden, as baby boomers move into the retirement stage of their lives.
This, then, calls into question the Western world’s arbitrary 2% inflation target: might this now be too high? Will it result in overly accommodative monetary policy in order to push inflation up to 2%, and will this in turn result in more violent short term (cyclical) swings in the funds rate?
Clearly these are very difficult questions to answer, and whatever the structural rate there will be cyclical swings in the meantime. However, we should challenge our psychological predisposition to expect an inflationary environment (just because we have lived through the inflationary period of c.1965-2007 does not mean it is the norm), and consider the situation objectively.
From an investment perspective, we are careful not to be drawn into this “framing bias”, where our perception of reality is "framed" by our experiences, but rather view the information available to us objectively. With this in mind, as we look out to the medium term we expect that rates will (a) rise slowly and (b) settle at lower levels than previously seen. As such, we continue to position ourselves for a moderate rate rise in the short to medium term, and a shallow path to (the new, lower) ‘normality’.
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