Inflation, Back to the Future?
Seemingly all of a sudden there are a plethora of articles about inflation in the popular press. The articles address whether President Biden’s various spending proposals and other policies are likely to lead to an increase in inflation – an increase in the overall level of prices of goods and services. Some economists argue that inflation is not a worry, others are expressing concern.
Two economists in the former camp are Paul Krugman, a Nobel Laureate and Emeritus Professor at Princeton, and Alan Blinder, a former Vice-Chair of the Federal Reserve and current Professor at Princeton. Krugman on March 22 published in the New York Times “How Not to Panic About Inflation” and argued that a few months of data suggesting increases in inflation was far too insignificant to draw any conclusions; also, that inflation Cassandras were wrong in 2008 when President Obama initiated stimulus efforts after the great financial crisis and are likely to be wrong again now. For his part, Blinder, apparently using the same headline writer, wrote in the Wall Street Journal on March 15 under “There’s No Need to Panic About a Little Inflation” that alleviating unemployment is more important than inflation concerns, and that when unemployment was low prior to the pandemic “inflation trended slightly down, not up.”
By contrast, Larry Summers, President Clinton’s Treasury Secretary, is raising alarms, telling Bloomberg News that we have “the least responsible fiscal macroeconomic policy we’ve had for the last 40 years.” Similarly, Steven Rattner, President Obama’s choice to lead the Task Force on the Auto Industry, wrote in the New York Times on March 5 that with easy money from the Fed, an additional stimulus from Congress and pent-up demand being released by the vaccination campaign, he is “worrying again” and that “warning signs have begun flashing.” So, economists disagree, surprised?
In truth, the United States has not experienced significant inflationary pressures since the early 1980s, when Paul Volcker, the Chairman of the Federal Reserve, dramatically raised short term interest rates, breaking the “Great Inflation” that had trended over 10% for many years, reaching a high of over 13% in 1979. Since the mid-80s inflation has appeared to be tamed, rarely exceeding 5% over the last 30 years.
What accounts for this apparent long-term thwarting of inflation – a highly destabilizing phenomenon last experienced so long ago that that it may seem to many like ancient history, almost as distant as the hyperinflation that beset Germany after World War I.¹
In The Great Demographic Reversal, Aging Societies, Waning Inequality, and an Inflation Revival authors Charles Goodhart, retired from The London School of Economics and a former Chief Adviser at the Bank of England, and Manoj Pradhan, founder of research firm Talking Heads Macro, argue persuasively that the world has enjoyed a “sweet spot” over the last thirty years that has dictated the path of inflation, and that is not repeatable over the next thirty.
The “sweet spot” identified by Goodhart and Pradhan, as indicated by their title, was a demographic phenomenon. In a nutshell, over the past 30 years, many hundreds of millions of new workers have been brought into the global economy, causing an effective glut of the labor markets, and thereby driving down the cost of labor in the global marketplace.
Where did all of these new workers come from? Primarily China – the integration of China into the world economy “more than doubled the available labor supply for the production of tradeable products among the advanced economies.” And almost at the same time as China began its integration, the “Iron Curtain” fell, leading to “yet another boost to the world’s effective labor supply” by bringing hundreds of millions of eastern European workers “into the world’s trading system.” This demographic “sweet spot” was further enhanced by (1) the rising number of workers in most developed economies compared to the number of non-workers (non-workers are the young and the retired); and (2) the further integration of women into the workforce particularly in Western European economies. All of these developments caused a “supply shock to labor” resulting in “a fall in real wages” especially “in advanced countries.” “No wonder that the deflationary forces have been so strong” and these “forces” are the reason inflation has “remain[ed] at, or more recently below, Central Bank targets, mostly set at about 2%.”
But, and here is the rub, these “forces” are not recurring and some indicia are likely to reverse, meaning that the sweet spot is “slowly turning sour.” First, China’s workforce is now shrinking, the integration of its rural population into its industrial zones is largely complete, as is its integration into the global economy. In the Western Economies, the workforce will similarly shrink as the baby boomers retire, creating a surge in the elderly, most of whom will as they age and live longer become dependent on others, but there is no evidence of an increase in birth rates to offset this surge in the elderly.
These and other factors lead the authors to their “deeply counter conventional inference” that “we are at a point of inflexion” with the “re-birth of inflation” being “our highest conviction view among the effects of demographics.” Because the “supply shock” of vast numbers of new workers entering the workforce is ending, and in some circumstances reversing, “labor scarcity” will “put them in a stronger bargaining position” to demand higher wages which “is a recipe for recrudesce of inflationary pressures.”²
Finally, in a post-script written after the initial manuscript was sent to the publisher, the authors consider the impact of the pandemic on their thesis. Perhaps not surprisingly, they join the camp finding that governmental policies responding to the resulting economic dislocations are likely to accelerate the trends they predict. As “the lockdown gets lifted and recovery ensues, following a period of massive fiscal and monetary expansion”, there “will be a surge in inflation” coming “to our doors faster than we had expected, thanks to the pandemic.”
Goodhart and Pradhan’s book presents a persuasive hypothesis for why inflation was tame over the past three decades. And while it also presents a persuasive case that the conditions that gave rise to this taming are ending, does it provide actionable intelligence that prudent investors should use to set investment strategy over the next five to ten years? We think not.
First, we return to one of PMA’s mantras, echoing Yogi Berra, that it is “tough to make predictions, especially about the future.” While Goodhart/Pradhan’s forecasts are reasonable and based on solid demographic assumptions, they cannot predict everything. For example, better than expected growth in productivity, meaning the ability of companies to produce goods and services using less resources, would at least temper inflationary forces by reducing the costs of production, even with a reduction in the supply, and subsequent increase in the cost of, labor. Second, Goodhart and Pradhan seem to hedge against exact predictions as to when this secular change will commence, how bad the inflation increase will be, and for exactly how long it will last. Betting on an amorphous expectation of increased inflation sometime in the next twenty years does not seem prudent. In addition, taking a long-term perspective is also important. A diversified exposure to equities, which many of our clients currently hold, is one of the best longer term “hedges” against inflation risk. Since 1928, the U.S. stock market is up 9.8% per year while inflation has averaged 3% per year. PMA is monitoring the inflation outlook in the United States carefully and may make changes to our clients’ portfolios for risk control purposes as market conditions evolve.
PMA does, however, strongly agree with the contention made at the end of this book, that the “future is nothing like the past” – and for this reason we should discard our assumption that what we have gotten used to for 30 years, be it low inflation rates or any other economic phenomenon that feels permanent due to its recent persistence, must continue for another 30.
¹ Germany post WWI used its printing press to finance its massive debts and distribute payments to certain constituencies, causing the exchange rate of the mark to the dollar to go from 192 to 1 in late 1919, to 4,200,000,000,000 to 1 in late 1923. Effectively, the hyperinflation eliminated much of the savings of the German middle class by making the currency that stored those savings worthless. Thomas Mann, the German Nobel Laureate in literature, who self-exiled from Germany in 1933, wrote that the hyperinflation made Germans “cynical, hardhearted and indifferent.” A “straight line” runs “from the madness of the German Inflation to the madness of the Third Reich” — having “been robbed, the Germans became a nation of robbers.” German memories of the hyperinflation haunt it to this day and reverberate around Europe given Germany’s influence over Euro based monetary policy.