Inflation Is Not Dead, It’s Just Changed Course

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Some economists maintain that persistent disinflation – and the consequent threat of deflation – should make the central banks reduce their current common inflation target of 2%.

This stance is a response to the increasingly more widely-held belief that monetary policy based on quantitative flexibility has been inefficient in terms of producing inflation and driving economic growth.

But, according to Lukas Daalder, Robeco Investment Solutions Investment Director, this doesn’t have to be the case. He says inflation is still there, although it’s currently more noticeable in the prices of financial assets rather than in those of more traditional goods and services.

It’s likely that the central banks will maintain their 2% inflation objective. This is despite the fact this figure has not been established as an optimum one based on academic studies – in fact it was chosen arbitrarily by New Zealand in 1989.

The European Central Bank, the US Federal Reserve, the Bank of Japan and the Bank of England keep this 2% target, although inflation in their countries has remained below this for rate almost the last ten years.

Why has inflation declined?

Daalder says there are various reasons why the threat of inflation – which decades ago ran at double digit rates and was capable of destabilising whole economies – has declined so much in modern times. The first one is digitalization. This has revolutionised sectors like the media, photography or music, by making additional copies available of news, games or songs for practically nothing.

Another reason is the fact that workers have lost power in the labour market. This is due to the decline in the trade union movement, globalisation and the continued automatization of industries which previously needed a lot of of manpower.

Demographic ageing is also deflationary, given that older people tend to save less. On the other hand, oil has ceased to influence the markets, as other forms of energy, like shale gas or solar, have caused oil prices to drop.

 “All these arguments indicate that there has been a structural weakness in inflation, a theory which is backed by the figures registered over the last few years,” Daalder says.

“This begs the question of what will happen if the central banks continue working with an inflation target of close to 2%, while given that the economy’s current dynamic, it’s likely it will never reach that level.”

A “monetary phenomen” 

“Economist Milton Friedman once said: ‘Inflation is a monetary phenomenon. It’s the central bank which fuels it or holds it back.’ If that’s the case, why have the central banks not managed to reach their 2% target? Under normal conditions, an increase in liquidity would have given rise to a situation which Friedman himself describes as ‘too much money chasing too few products.’ This  would have produced inflation.

“The response is that this inflation has, in fact, materialised. But not in goods and services but in the financial markets. There has been a strong recovery in the property markets and the S&P 500 offers a Shiller P/E ratio of 30,3, while the rates on fixed income securities are abnormally low (implying a rise in bond prices). All these factors can be considered as signs of inflation in financial asset prices. That said, as these assets are not taken into account for the central banks’ inflation targets, we don’t consider them as inflationary.”

Alternative prospects

Daalder says there is another group of economists who accept that disinflation can be attributed to these reasons, but they prefer to focus on the risks associated with the decline inflation and the future outlook. They maintain that monetary policy’s lack of effectiveness in generating inflation, using interest rates as the main tool, highlights the need to adopt other methods.

They also affirm that, traditionally, salaries tend to remain low. So it’s easier to fire people than increase their wages, which can potentially damage the economy. And allowing inflation to decrease gradually means that the level of indebtendess increases with time (supposing that interest rates don’t change): if a person takes on a 30-year mortgage, counting on inflation being around 2%, his debt will increase if inflation structurally declines. In Daalder’s view:

Judging by comments from the representatives of the different central banks, it seems the majority belong to this second group. This seems to foster  the typical rise and fall scenario: the central banks inject too much liquidity into the system, creating ‘inflation’ in the wrong places.

But there is also a more encouraging possibility: the prospect of conventional inflation returning, albeit with something of a delay. Daalder says Robeco “is against adopting the belief that inflation is dead.” He explains:

This is partly because in the past similar things have been said – it reminds us quite a bit of the argument that ‘the economic cycle is dead’, which we hear again every ten year or so – but also because we don’t believe inflation can ever be erradicated.

As long as there is no perfect equivalence between supply and demand, inflation will form part of our system. It’s worth pointing out that saturation is re-appearing in the labour markets, where demand exceeds supply. It might be that the technological transition has delayed salary hikes, but we don’t believe there are reasons for that not happening at some point. In such a situation – which is our main assumption- inflation will come back after taking a breather and, consequently, the interest on fixed income will also rise.