Linchpin 2019 Inflation Update
William Bourne has since 2012 written an annual update on the long-term outlook for inflation by monitoring shifts in a varied range of inflation indicators. Last year for the first time the consensus tipped towards inflation: we agreed on the direction of travel but argued significant rises were not yet imminent. One year on, austerity has clearly been abandoned, and protectionism is on the march: we consider both to be inflationary. On the other hand, the US Federal Reserve’s determination to cap inflation will in our view lead to an economic slowdown, which is deflationary.
A year ago we concluded that deflationary forces had after 25 years finally been outweighed by more inflationary ones. Behind this lay secular indebtedness, shifts in relative power between capital and labour in the West, and a cyclical upswing in Emerging Markets economies. We argued that higher inflation is inevitable eventually but placed more emphasis on market indicators suggesting not quite yet.
Headline numbers in 2018 have continued to rise gently to around 2% in most of the world. Japan is an outlier below this number and the US an outlier above.
The final abandonment of fiscal austerity by most developed countries is clearly inflationary in the long term. Not only does it build up government debt level, but by adding to demand it increases pressures in areas such as labour costs. It confirms our view that western money will ultimately be debased.
Under the traditional model, new demand would be filled first from spare capacity. Today the output gap is minimal in most countries, and the new demand is often in different industries and areas to where excess supply lies. We have not changed the indicator for the output gap, but we have for deleveraging - really it is now a case of leveraging.
In 2017 commodity prices rose by 8% and we marked them as Inflationary. In 2018 non-energy prices were not greatly changed but oil prices rose by around 25%, so we have maintained this measure as Inflationary.
The growth in trade friction is another factor leaning towards inflation, both prima facie as tariffs are added to goods but also in the longer term as competitive pricing pressures reduce. We have moved the Costs indicator (re-named from Labour Costs) to Inflationary.
Last year it was the market indicators, and primarily bond yields, that made us hesitate about predicting an immediate rise in inflation. A year later, US bond yields have risen decisively, with 10-year bond yields categorically breaking up through 3% before falling back. Other sovereign bond yields have not risen by much in 2018 suggesting that, outside the US, inflationary pressures are likely to remain muted. We have therefore retained bond yields at Neutral.
Monetary policy is very tight around the world except for China. The US Federal Reserve is in our view on the verge of making a policy error by over-focusing on inflation concerns. This is how most recessions are caused, and we now expect at best a slow-down, at worst a recession. Having said this, the Federal Reserve has softened its tone: while it is still talking further interest rate rises, Fed. Chairman Powell’s latest speech clearly prepares the ground for some backtracking. Notwithstanding, we have moved this indicator to Deflationary.
In summary, government fiscal policy seems inevitably to lead to higher inflation, but it is only coming through in some market and financial indicators. Our 13 indicators have moved in different directions, with two (cost pressures and deleveraging) indicating more inflation and two (lower growth and monetary policy) signalling lower.
Table showing direction of travel for inflation
Current market estimates of inflation
The current IMF forecasts for Advanced Economies are little changed, whether in the short term or five years out, at 1.9% (deflator measure, 1.8% twelve months ago) and 2.0% five years out (end period CPI, 1.9% twelve months ago). Estimates for Emerging Markets over the next five years average out at 4.2% end period CPI at the same time, compared to 3.9% 12 months ago. US consumer inflation, as measured by the Personal Core Expenditure (ie. ex food and energy) was 2.2% in November 2018 (2.1% a year ago). It peaked mid-year at 2.9% and has been falling back since.
In our view the final ditching of fiscal austerity, combined with the levels of debt in the West and an increased level of political dysfunction, bakes in higher inflation in the longer term. However, in the short term the forces may actually be pulling in the other direction: we believe that the ECB and the Federal Reserve are on the verge of making a policy error by running too tight a monetary policy and economic growth has probably peaked this cycle. That may be what market indicators, and particularly bond yields, are telling us.
If you would like to discuss anything in this article with the author, please contact us.