US Inflation in Focus

With the last decade dominated by modest US growth, the investment environment has largely waxed and waned on the inflation outlook, with market participants swinging wildly from deflation fears to worries about inflation breakouts. Currently, views about the inflation outlook are extremely split: with some focusing on the deflationary impacts of the balance sheet deterioration that is occurring to all economic agents; and others focusing on the extreme policy response and the implicit inflationary impact.

To analyse the likely path of inflation we have approached it in a multi-faceted manner: using a traditional Keynesian approach; analysis using a monetarist framework; and simply estimating the impact of the recent volatility in oil prices. We find that core inflation is likely to rise and reach the US Federal Reserve’s old policy target of 2% in the near term. Also, there is likely to be a surge in headline inflation early next year. Given this, we find that markets are at risk of a surge in inflation fears. However, in the medium term we expect inflation to generally remain benign, as the aftereffects of the pandemic sees a continuation of the balance sheet repair trend in place since the GFC. This suggests that the inflation fear not to be sustained, and a continued waxing and waning of inflation is likely.

Further out, the outlook becomes more difficult to predict. While demographic modelling suggests higher inflation in the US, these models broke down in Japan, which is further along in the demographic aging process. Given the general belief of the “Japanisation” of the global economy this points to dis-inflationary pressures. The other issue is the US central bank’s use of the printing presses. While Japan does not suggest this is necessarily a problem, we know from history that risk from this type of policy is that inflation expectations become unanchored.

Keynesian approach

A Philips Curve based model was constructed: with the core PCE deflator a function of labour market utilisation (measured by U6 unemployment rate), energy prices (year on year change in consumer energy prices, current and lagged 4 quarters), and currency (quarter on quarter change in USD TWI, current and lagged one quarter) based on work by Goldman Sachs (Hatzius, 2015). The model output and actual outcomes are plotted in figure 1.

 Figure 1: Core PCE and Forecast – Phillips Curve Model

Source: Schroders, Datastream. Forecasts may not reflect actual outcomes.

The model fits the data relatively well (R squared 0.40) and the forecasts are based on a downward trend in the U6 unemployment rate and the USD TWI, with a rising trend in oil prices.  While it is always difficult to estimate the path of the underlying components, we have made some plausible assumptions. Based on the work of Bram and Deitz (2020) we have based the unemployment rate path on a “natural disaster” scenario, rather than a cyclical recession, seeing the unemployment rate steadily decline over the next few years. We also assumed a relatively aggressive fall in the US dollar, using the fall in the currency in the 2000s as a baseline. This is based on the “twin deficits” framework – the blow out in the budget deficit and continued current account deficits have historically been negative environments for the US dollar. Reflecting the weaker dollar, we have priced in a relatively robust bounce in oil prices (based on the bounce out of the last collapse in oil price from 2016).

These assumptions were used for two reasons. First, they are highly defendable and could easily be used as a base case outlook. Second, they are relatively bullish assumptions and therefore give an idea of the upside for inflation. Not surprisingly, the Phillips Curve model forecasts a higher inflation outcome. However, using the relatively aggressive assumptions core inflation only reaches the level of the policy target.

Monetarist approach

The quantity theory of money, which while dating back to 1500s, was reinvigorated in the 1950s by Milton Friedman and is another approach to forecasting inflation.  The broad concept of the theory is captioned by the saying “inflation is always and everywhere a monetary phenomenon”.  This theory is based on an identity, the equation of exchange:

M . V = P . Q
Where:
M is the total amount of money in circulation;
V is the velocity of money;
P is the price level associated with the transactions; and 
Q is an index of the real value of transactions.

The quantity theory of money takes this equation of exchange and assumes three things.  First, the demand for money, as reflected in its velocity, has a stable relationship based on factors like nominal income, interest rates etc.  Thus, velocity is relatively unchanging, seeing money supply as the key left side variable.  Second, the supply of money is exogenous - not a function of other factors - and is driven solely by central bank activity.  Third, production is driven by nonmonetary factors such as the productivity of labour and capital, and like velocity is relatively unchanging.  This sees the equation of exchange collapse to M = P, and suggests that inflation is a function of the growth rate of the money supply.

However, there are two issues with the assumptions made that suggests the relationship between money supply and inflation isn’t as simple as this theory suggests.  The first problem with this theory is how do you measure money?  Central banks have control over base money: notes and coins in circulation and bank reserves; but do not have direct control over broader measures of money.  This relationship is driven by the money multiplier, which is driven by credit creation, which is in turn driven by the supply and demand for credit.  Research generally shows that the relationship between money and inflation holds when money is measured by broad measures, and it is typically defined as the ratio of quarterly nominal GDP to the quarterly average stock of M2. 

The importance of the money multiplier does raise issue with the assumption that the supply of money is exogenous.  Balance sheet recessions, where individuals are driven by balance sheet repair (deleveraging) rather than profit maximisation, like the Great Depression and Japan during the 1990s, would see the quantity theory of money break down.

The other issue with the theory is the assumption that the velocity of money is stable.  This holds in normal conditions but breaks down at other times.  A good example is what happened during the global financial crisis, where the velocity of money fell sharply.  Disturbances in velocity are often the key factor in hyperinflations and severe deflationary environments.  In hyperinflations the velocity of money goes up dramatically.  With the value of money collapsing, sometimes on a minute by minute basis, there is a very high incentive to hold money for as short a period as possible, this causes velocity to increase.  While in deflationary environments, with prices falling, there is no incentive to purchase goods and services quickly, so the velocity of money falls.  In times where money supply is relatively stable, changes in velocity can provide a good lead on the inflation environment.

Figure 2: US core inflation and money velocity

Source: Datastream, Schroders.

Figure 2 plots the relationship between changes M2 velocity and core inflation, where the change in M2 velocity leads core inflation by almost 2 years. The unprecedented monetary policy easing that has occurred during this crisis has also been accompanied by a collapse in money velocity, and a dis-inflationary response. In the short run this is consistent with low inflation. Money velocity would be expected to pick up once the economy normalises, but a key question is to what extent. This has the potential for longer lasting impacts.

Recently we explored the economics of the COVID pandemic and the policy response (Stevenson, 2020). One issue discussed was the long-lasting impact of past pandemics on economies, up to 40 years.  This is primarily through changes on the capital to labour ratios, due to the loss of life of the working age population. We noted that the current pandemic while tragic in human terms, has fatalities skewed to the age cohort of over 60. Given this age bracket participates significantly less in the labour market, it will have less impact on the capital to labour ratio and therefore economically. We have also become much better in managing pandemics, with social distancing successfully reducing fatalities so far relative to the potential worst-case outcomes.

This suggests that the impact of the current pandemic will be much shorter that previously. However, we do expect to see an impact through a “heightened desire to save” channel, due to a deterioration in balance sheets across all economic agents. This is expected to see the balance sheet repair trend that has occurred since the GFC continue and would be expected to see a cap on the velocity of money, limiting the upside to inflation.

Oil prices and inflation

Large swings in oil prices have an outsized impact on headline inflation. Falls and rises in oil prices show up in inflation measures over an extended period of time due to the fact that inflation is a measure of 12 month price changes. Therefore, large movements in oil prices give a heads-up on the future movement in inflation. Figure 3 shows this relationship in a simple way. If we assume current oil prices are maintained for the foreseeable future the impact on headline inflation will be extremely significant.

Figure 3: US headline inflation and oil prices

Source: Datastream, Schroders. Forecasts may not reflect actual outcomes.

Research shows inflation expectations are adaptive, i.e. they are mostly backward looking. We highlighted this last time oil prices bounced significantly - from the 2016 low – which gave us advanced warning of the inflation fears that dominated a large part of 2017. There is a high risk of this occurring in 2021, especially given the percentage change in oil prices is so outsized.

Medium term drivers

While we paint a relatively benign outlook for inflation in the medium term there are a few issues that may be problematic to this outcome: demographics and geopolitics. Modelling suggests a relatively strong relationship between age structure and inflation regimes. This theory linking the two is based on the lifecycle hypothesis of income smoothing. With young adults and the very elderly high consumers relative to their income, high proportions of these cohorts have been correlated with high inflation regimes. The elderly is an interesting dynamic, with health spending rising sharply in the last years of life, models often find this age group inflationary, and with the aging of the populations in many developed economies, it suggests a potential for a regime change. However, Japan, an economy that leads other developed nations in terms of aging, has seen these models break down, with inflation much lower than the models predicted. Suggesting demographics may not be an inflationary factor.

The other factor is the turn in geopolitics leading to a somewhat of an unwind in globalisation. We expect this trend to continue and think that the likely terminal point is a world split by two trading blocks. The pandemic is likely to accelerate this trend as corporates adjust supply chains to make them more resilient to future shocks. However, supply chains will not necessarily move to high cost nations, but to other low-cost producers, with Europe likely to move production to Eastern Europe and USA to South America. Also, the structural effect of this deglobalisation are likely to take decades to feed through, minimising the annual impact.

Implications

With our analysis suggesting that inflation pressures will rise from here, with an upward drift in core inflation to the Fed’s old 2% inflation target, and headline inflation likely to surge early next year. This has the potential to lead to another round of fear of an inflation breakout. While, previously this would have led to rate hikes from the Fed, the move to a “inflation averaging” framework adds uncertainty to the likely response. 

What we do know is that the long end of the US bond market will respond, as this is the most inflation sensitive part of the year curve, and if the Fed is less responsive to inflation, the yield curve would be expected to steepen.

Equity markets have historically been vulnerable to shifts to inflation fear, with significant drawdowns often occurring. However, the causality is not clear, is the vulnerability due to rising bond yields and the lift in implied discount rates, or due to the policy response, which suggests a weaker economic and therefore profit outlook. With inflation average potentially separating out these factors, the outlook is more uncertain. However, with valuations stretched, especially in the US, some caution would be recommended.

References

Bram J. and R. Deitz, (2020), “The Coronavirus Shock Looks More Like A Natural Disaster Than A Cyclical Downturn”, Liberty Street Economics, Federal Reserve Bank of New York, April 10.

Hatzius, J. (2015), “The Risks to Inflation, and to Liftoff in 2015”, Goldman Sachs US Daily, 7 January.

Stevenson, S. (2020), “Covid-19, social distancing and the flood of money – Will the policy response be effective and what are the likely lasting impacts?”, Schroders Talking Point.