We keep asking ourselves why inflation remains so low in the developed world, despite the fact that countries (the US especially) are at or approaching full employment. Based on the famous Philips Curve relationship, it used to be the case that, as countries approached full employment, the capacity constraints caused by filling new jobs and the greater purchasing power on behalf of employees vs. employers would result in wage inflation. But we find ourselves scratching our heads, as this relationship does not appear to be holding true.
We are not the only ones who are confused. The subject of whether the Phillips Curve is dead or has ceased to be relevant was debated at length at the recent Jackson Hole symposium of central bankers and even they can’t seem to agree whether the break in the relationship is transient or structural.
Judging by the minutes of its July meeting, the ECB appears to be in the “it’s structural” camp. Quote: “These included changes in labour markets, work contracts and wage-setting processes, benefiting from the reforms introduced in previous years, which could imply a structural break in the Phillips Curve.”
It is our opinion that for now, the Phillips Curve has stopped being as timeous at predicting inflation due to specific factors that have been termed “the 3 Ds”, namely Debt, Demographics and Disruption.
Starting with Debt, it might surprise readers to know that global debt levels are now higher than they were before the Global Financial Crisis. Higher debt levels, ceteris paribus, means that consumers are forced to pay down debt and thus have less money to spend. This in turn leads to reduced pricing power for companies when increasing their prices. The debt/income level since 1959 in the US has nearly doubled from 12.5% in January 1959 to 23.5% in June of this year of 2017. In aggregate, nominal incomes have increased 40 times while consumer credit has increased 70 times since 1959. This would suggest that, even with unemployment below the natural rate, disposable incomes have declined as a result of the increases in debt.
Using a usual Phillips Curve model, from data going back to 1959, a target inflation rate would be 3.2% in the long term as a result of such low unemployment numbers. However, using the same method to project inflation, including debt to income ratios, target inflation for the same period is 1.14%. What was more interesting is the debt to income metrics had a higher impact on inflation that unemployment numbers, highlighting the flaws of the original Phillip’s Curve.
Next up we have Demographics. As individuals age, their spending habits change. When individuals are young their spending generally exceeds their savings, putting upward pressure on prices. Conversely, as an individual ages, savings exceed spending and this causes downwards pressure on prices. As a whole, the world has crossed the tipping point when net savings turn positive. The global median age has risen to 30 from 21 in 1975. Developed countries’ median age approaches 42, which is close to peak accumulation (Sources Forbes). The demographic explanation also works on a cross-country basis. The regions most affected with deflation (Europe, Japan) are also the oldest. The U.S. and the U.K. owe their relatively high rates of inflation to their comparatively younger populations and higher immigration rates.
And then we have Disruption, which has completely turned the whole notion of inflation on its head. By disruption I mean the activities and business models of the likes of Amazon, Airbnb and Uber, to name but a few. These particular companies have disintermediated traditional players in their markets and have made the pricing power of the incumbents virtually non-existent.
The long and short of the three Ds that we have highlighted means, to us, that the traditional methodologies of calculating inflation are falling by the wayside. In future, therefore, central banks will be less likely to raise interest rates because of wage and price inflation than because of asset inflation (just look at the S&P 500!) and the risks represented by moral hazard. For now, however, they remain backwards-looking and relying on old models that have ceased to be relevant. On the bright side, as central banks continue to analyse the wrong data, markets will be well supported by abundant liquidity.An Inflation Conundrum and the Three Ds