Inflation bulls are currently in the ascendency. The US Fed raised its overnight rate again in June and is discussing the unwinding of quantitative easing (QE). The European Central Bank Governor Mario Draghi now says that the "deflationary forces have been replaced by reflationary forces". It is good to talk up inflation, but let's not get too excited. A look at the long term interest rates picture shows that deflationary forces were decades in the making. Have those forces really now reversed? Or, are we simply in a hiatus before the fight against deflation resumes in earnest?
Figure 1: 10 year Government bond yields 1950-2015
The story of US inflation and long term interest rates since 1950 is a simple one. There has been a single cycle of inflation and interest rates rising in the US from 1950 to 1982 and then falling from 1982 to 2015, as shown in the graph above.
The turning point of 1982 was the year that the then Governor of the US Federal Reserve Paul Volker acted to squeeze inflation out of the US economy by raising short term rates until the global economy was plunged into a deep recession. With a few ups and downs, US long term interest rates have fallen ever since. In many other countries, including Australia, inflation and interest rates peaked earlier than 1982.
A New Cycle?
Since early 2015 there has been a hiatus, with inflation in the major developed economies neither rising nor falling substantially, but instead hovering between 1 and 2%.
What happens next is the biggest question faced by global investors. Have we reached a turning point and the beginning of a new cycle in which inflation starts to accelerate? Or alternatively, will the current cycle continue with ongoing deflationary pressures forcing inflation and long term interest rates to still lower levels?
Investors cannot avoid taking a position on inflation expectations. It is the single most important question that investors face today in their long term investment planning.
Investors who believe that inflation and interest rates are about to rise will reduce their exposure to assets that deliver long term cash flows that don't rise with inflation. That especially means selling long term fixed rate bonds, and fixing interest rates on their long term borrowing.
But it is not just debt. Shares will suffer too -- especially US equities -- if investors believe that higher inflation will allow an unwinding of QE. It is no coincidence that the 35 year bull market in US equities started in 1982. If inflation starts rising then that party will finally be over.
Mario Draghi and Janet Yellen, and other inflation bulls, believe that a new era has in fact begun. They don't, of course, believe that we are entering a re-run of 1950-2015. But they do believe that the post-1982 period of falling inflation has come to a close, and they intend to act accordingly.
Yellen and Draghi see rising inflation as the inevitable consequence of shrinking surplus capacity and growing confidence in the US and Europe. US and European employment figures are especially important here. US unemployment has fallen well below the historical level at which wage inflation kicks in, as firms compete for workers and workers feel more confident in demanding higher wages.
When it comes to the connection between confidence and interest rates, Janet Yellen sees both both cause and effect. The effect of rising confidence among businesses and households in the US and Europe will be to stimulate aggregate demand. Inflation and interest rates will rise as a consequence.
But rising interest rates can also be the cause of improved confidence. Janet Yellen believes that confidence will only return once every part of the GFC is a long way back in the rear vision mirror. She believes that everything that was broken in the GFC is now fixed - unemployment has fallen, the banks are recapitalised, debt growth is arrested. The last piece, in putting Humpty Dumpty back together again, is to get interest rates back to normal and to unwind QE. Until that is done the GFC is not fully over and a sense of crisis will linger. Higher interest rates would have the confidence boosting effect of making households believe the GFC is finally over.
Have Deflationary Forces Abated?
Inflation bears are unconvinced. Bears find the graph above compelling and sobering. There have been many short periods since 1982 during which inflation and interest rates have moved up, but then their secular decline resumes. Bears want to see the evidence that a permanent increase in inflation is coming. Yes, they say, economic theory predicts rapidly rising inflation under the current circumstances. But, we are obviously operating outside the range of standard economic models, because those models have been predicting rising inflation for a long time now, and it has not eventuated.
Inflation bears ask the following question 'why do you think that deflationary forces have abated?' That is a valid and crucial question. Investors should consider the forces that drove US inflation from 13.5% in 1980 to 1.3% in 2016, and whether those forces are now diminished.
Population Growth: After WWII population growth accelerated around the world. But since the early 1980s population growth has slowed in every part of the world except Africa. Japan and Italy are the developed nations that have suffered the most dramatic population ageing and they have also experienced the slowest economic growth in the last 2 decades. Japan's struggle with deflation over the last 25 years is surely closely related to its rapidly ageing population. Most developed countries are heading down the same demographic road (but not Australia, I am happy to say).
Debt levels: Deregulation of financial systems in the 1970s and 1980s allowed the expansion of the financial system and the accumulation of vast volumes of debt, which in turn supported higher aggregate demand. Total global debt across households, corporations and governments has continued to rise as a proportion of global GDP since the GFC, albeit at a slower rate. The levels of debt accumulated since the early 1980s forms an 'overhang' of the economy which stifles aggregate spending and investment plans.
Technological improvements: Rapid technological innovation has caused two downward forces on prices. First, it has increased supply of goods and services without requiring high investment spending. When existing assets are made more productive by information technology there is more aggregate supply without the matching aggregate demand in the economy in the form of capital investment.
The second effect of rapid technological innovation is that it undermines consumers' confidence in their employment security and business confidence in investment plans. Since the GFC the missing part of aggregate demand has been corporate investment.
Concentration of wealth: The concentration of wealth that has occurred in developing countries since the early 1980s has put a greater percentage of total income into the hands of families that have a higher propensity to save.
Energy prices: The supply of commodities of all kinds has outstripped demand since the late 1970s. The emergence of China created a surge in commodity prices in the first decade of this century, but supply has caught up since. This is especially true of energy prices.
The deflationary forces listed above are powerful, enduring and systematic. Which of these forces is now reduced, so that inflationary forces might dominate? Population ageing? Technological improvement? Saving imbalances?
Going Too Early
It is very helpful for Yellen, Draghi and other central banks to talk up inflation. Expectations of future inflation are a self fulfilling prophecy. Firms will raise prices and workers will demand higher wages if they believe that higher inflation is on the way. Likewise, deflationary expectations are self fulfilling. Apart from Japan's Prime Minister Shinzo Abe, politicians and central bankers have not done enough to create and sustain higher expectations of inflation.
Talking up inflation is good, but actually raising interest rates and unwinding QE too early could be a massive mistake by Yellen and Draghi. Yellen desperately wants a return to normality, which means higher interest rates and unwinding of QE, as I said above. The danger is that deflationary forces have not abated and inflation resumes its decades long decline.
It is one thing to want higher inflation, it is another to expect it to happen in the short to medium term. Investors need to be careful about being drawn into wishful thinking on inflation and interest rates. It might be better to plan for the Fed making a big mistake than to plan for a reversal of the decades long declines in interests rates and inflation.