There has been a material shift in central bank pricing since the start of the year. The Fed, who were priced to hike twice in 2019 not too long ago, are now priced to cut at least once. The ECB is not expected to get back to positive rates for at least three years whilst the RBA is fully priced for two cuts.
The move was originally driven by the Fed’s pivot towards inflation and their desire to avoid a de-anchoring of inflation expectations, a phenomenon that has occurred in Japan and Europe after years of inflation misses.
That said, unemployment rates are at multi-cycle lows across most developed markets, and in some cases, all-time lows. This begs the question, why is inflation so low?
Below I present a selection of possible reasons that may help explain the disappointing inflation dynamics.
Most economic models focus on the unemployment rate as a measure of slack, however, this is not necessarily the best measure. As labour markets have tightened, participation rates have picked up dramatically, especially amongst prime age women and older segments of the population. This trend cannot go on forever but there is still some scope for cyclical rises in participation rates. This keeps a lid on wage inflation and helps an economy to continue to grow above their potential without generating inflationary pressures.
2. Margins, not Prices
Whilst hidden slack may put a lid on runaway wage growth, we have still seen some progress in the last few years, especially in the US and more recently in the Eurozone. The Phillips curve is often described in terms of wage growth with the resulting assumption that higher wage growth boosts inflation (absent a rise in productivity). However, this wage-price relationship broke down some time ago. The missing link is profit margins. Globalization, technology and the spread of information has made it much harder for firms to raise prices, especially when inflation has been so well contained over the last few decades. Hence the more important series to watch is profit margins – if firms cannot raise prices, the next recession will come from stress on earnings rather than the central bank hiking to prevent inflation.
On this measure, we may still have some way to go. Whilst gross profit margins have fallen from their peak, last year’s tax cuts boosted net profit margins significantly whilst stronger economic growth has also fed through to gross margins to some extent.
3. What Inflation matters?
The problem with most inflation baskets is that not all the components are cyclical. For example, in the US, healthcare is greatly impacted by regulation whilst core goods are impacted by import costs. In fact, the most cyclical part of the inflation basket, shelter, has been rising at a steady pace. The rest of services CPI looks volatile and acyclical. Put simply, it is very hard to achieve an inflation target when such a large proportion of the basket is out of the central bank’s control.
4. The Amazon Effect
Structural forces also push down inflation, especially in core goods. Whilst online shopping does not directly impact CPI (due to outlet bias*), increased competition and better access to information puts downward pressure on the entire goods basket.
Splitting core goods (roughly 50/50) into an online** and offline basket, you can see that offline inflation is structurally higher than online inflation. You would expect this if goods that are traded online more frequently are subject to more competition.
The caveat here is that the difference in online and offline CPI (the following chart) has not increased. If anything, the big shift was during the 90s, and the difference has been relatively stable since. You can read this chart in many ways. My impression is that the Amazon effect impacts the entire goods basket (even the more offline segments) more so that it did previously.
5. Entrenched Expectations
This leads me to my final reason. Low inflation itself is a reason for low inflation. People are very much backward looking and successive disappointments in inflation, whether cyclical or structural, impact inflation expectations. It takes time to influence inflation expectations, hence the Fed’s desire to avoid the inflation trap that Europe and Japan find themselves in.
What does this mean for markets?
All else equal, central banks that are more focused on inflation will continue to keep monetary policy easier than previously expected, regardless of strong labour markets. Furthermore, given the myriad of structural forces and acylical inflation mentioned above, central banks may struggle to boost inflation consistently. Once you add the growing trade risks on top of this, we believe portfolios will continue to benefit from being positioned long duration.
*Outlet bias: Consumer shifts to new outlets, such as online shopping, is not well-represented by CPI since the difference in price levels between outlets is not captured.
**Online CPI: CPI of the most ecommerce intensive parts of the core goods CPI basket