- Market Commentary
- By Jack Ablin
- November 21, 2019
Is Inflation Dead?
Inflation is not the threat it once was, nor is it as easy to conjure up as the Federal Reserve once believed it to be. It’s been more than 10 years since the global financial crisis and, despite its zero-interest-rate policy and $4 trillion of quantitative easing, the Fed’s extraordinary measures have done little to revive inflation. In fact, US inflation has remained below the Fed’s 2 per cent target 90 per cent of the time since these efforts were unleashed 10 years ago.
The Fed chose its 2 per cent inflation target to allow comfort and confidence on Main Street, while facilitating debt service for borrowers. Moreover, 2 per cent is far enough away from zero to insulate the economy from the corrosive effects of deflation. While inflation fell for eight consecutive months at the bottom of the financial crisis, the US economy has endured only three months, in 2015, when prices contracted year over year.
The seeds of inflation germinate from imbalances in the supply of and the demand for goods and services. Of course, prices of individual goods and services rise and fall routinely, but inflation is a general price response. Some important aspects of today’s economy have the potential to influence the path of prices.
The single biggest source of inflation pressure comes from the labor market, where demand for qualified workers is outstripping supply. Today’s unemployment rate, at 3.6 per cent, is near its lowest level since 1969. Historically, tight labor conditions exert wage pressure as employers compete for fewer available workers. The last time the unemployment rate was this low, wages grew at 6.4 per cent. Nowadays, however, wages are growing at less than half that rate.
Several factors are attenuating wage pressure this time around. In 1969, nearly one-third of private-sector employees were unionized. Collective bargaining, wage contracts and the threat of strikes gave employees more leverage to fight for wage increases. Now, leverage has shifted to employers, for reasons including industry concentration. Fewer, larger companies account for a greater market share in their industries. These companies emphasize shareholder returns over wage compensation. Labor mobility – the ability to shift companies in similar industries for higher pay – has been thwarted by the proliferation of non-compete employment agreements, particularly among skilled workers. It is estimated that nearly 60 per cent of highly compensated employees are restricted by such agreements.
Trade tariffs would appear to be an obvious source of pricing pressure. However, goods inflation remains subdued, posting just a 0.3 per cent advance over the 12 months ended October 31. Yuan weakness has contributed to the decline, with the Chinese currency having lost about 3 per cent of its value over the last six months. Dollar strength, more broadly, has kept a lid on price inflation from imports in general. The greenback has strengthened by more than 30 per cent over the last decade, sending goods prices into retrograde for most of the last five years.
Other factors systemically weighing on inflation include demographics and technology. Innovation continuously drives the cost of doing business downward. Sharing apps, like Uber, Lyft and Airbnb, have exerted pricing pressure on established providers, like taxis, limo companies and hoteliers. Technology has also disintermediated the middlemen in a variety of sectors, including the entertainment industry, by moving content providers closer to end users while cascading cable bills. Technology helped drive brokerage giant Charles Schwab’s desire to acquire TD Ameritrade. The consolidation fits the deflation narrative, in which the former slashed brokerage commission costs to zero and the latter reluctantly followed suit.
Demographics is one of the most dominant factors affecting prices. Disinflation trends tend to correlate very closely with aging populations. Goods demand among retirees is softer than demand among young people who are starting their careers, forming families and buying homes. More than 15 per cent of the US population is over the age of 65; in Germany it is 22 per cent, and it is 28 per cent in Japan.
Inflation, in many respects, is self-fulfilling, as recent pricing experience tends to influence consumer expectations and buying behavior. Consumers anticipating inflation tend to accelerate their purchases, leading to stronger demand and higher prices. The urgency to purchase is absent in a stable or deteriorating pricing environment, leading to reduced current demand. Consumer inflation expectations have declined in recent years in response to tepid inflation readings and have held within a tight range between 1.9 per cent and 2.4 per cent.
We expect inflation readings to remain tame for the foreseeable future, as global forces continue to pummel price growth. This will exert a downward bias on interest rates as central banks pull out additional stops to stem deflationary forces. These trends will favor high-quality corporate bonds, consumer credit and equity sectors with pricing power. This landscape also tends to favor the technology sector, which has spent decades thriving in a deflationary environment.