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Demise of the deflation machine

Jamie Dannhauser
Economist

The global economy has been inherently disinflationary since at least the early 1990s. The result: a generation of investors who have never had to take inflation risk seriously.

But the predominant, powerful and persistent deflationary forces of recent decades – some technological, some political and some demographic – are dissipating. In some cases, they already have. The demise of the deflation machine is now at hand.

A more inflationary and volatile world

We should not be surprised that rebooting an economic system, deliberately put into hibernation as the pandemic’s first wave raged, is proving to be disruptive; nor that economic reopening is being accompanied by dramatic price hikes along supply chains struggling to adjust to radically different patterns of global demand. Restructuring the economy to meet changed consumer habits will be neither swift nor painless.

This crisis, and the response to it, have generated inflationary momentum not seen in many years, but it is best considered an accelerant of trends – economic, political, geopolitical and social – slowly building in the world economy ever since the financial system was brought to its knees in 2008/2009.

 

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The return of the Big State

The pandemic has changed the calculus – inflationary regime change is now a clear and present danger to investors.

We now know what was previously uncertain: that, scarred by the fallout from the 2008/2009 crisis, the political elite would feel compelled to deploy the State’s balance sheet on whatever scale was necessary to shield the private sector from further economic harm. The same political logic has convinced policymakers substantial policy support must remain in place long after emerging from recession.

Disinflation and the digital revolution

The case for extreme policy stimulus was strengthened by the perception of a fundamentally disinflationary background environment. That were it not for the pandemic, inflation risk would remain an absent adversary. Central bankers proclaim whatever short-term disruption covid may have caused, the productivity-boosting tailwinds continue to blow fiercely.

We are sympathetic to the view digital technologies represent, like steam and electricity before them, a ‘general purpose technology’ (GPT), with wide application to all manner of business processes.

But the emergence and adoption of dramatic advances in computing power owed at least as much to political and social trends operating in the background. China emerged from economic obscurity, European nations entered monetary union and radically deepened the single market, and labour supply was boosted by the surge of female labour force participation.

In short, the digital revolution occurred alongside a massive, but ultimately one-time, expansion of the world’s productive capacity, principally its effective labour force.

A changed environment

But, apart from the previously mentioned technological advances, these disinflationary tailwinds have one thing in common: they are all now much diminished. The disinflationary potential of digital technologies is not to be dismissed, but the political, geopolitical and social environment of the next decade looks to be eminently hostile to those who hope to profit from them.

The political dynamics unleashed by the 2008/2009 crisis are inherently inflationary: they are anti-globalisation, anti-immigration and populist in nature.

This is happening amidst a profound geopolitical realignment between the world’s two economic superpowers – the US and China. The key feature of this economic disengagement is that just-in-time optimisation will give way to just-in-case redundancies in business planning. In the political marketplace, efficiency and growth, the overriding objectives of the pre-GFC regime, have given way to resilience and fairness as the core values that will dominate post-covid.

 

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Becoming inflation prone

If these so-called structural tailwinds had been so important and are now diminished, then why has inflation been so quiescent in the years since the GFC?

The underlying dynamics have not remained constant, despite consistently low observed inflation. Our argument is the world economy has become significantly more inflation prone over this period – more liable to developing its own self-reinforcing inflationary momentum in the face of unexpected developments and shocks.

After a decade of exceptionally loose monetary policy to offset lingering debt-deflationary headwinds, the economic system had become littered with inflationary dry-tinder, just waiting to be ignited.

The moment of maximum danger

The policymaking elite retain conviction the current spike inflation will subside. They may ultimately be proved right. Indeed, there is almost certainly going to be a period in the middle of next year when inflation rates – the level of prices today compared with twelve months ago – fall back towards central bank targets.

This will be the moment of maximum danger for investors and policymakers who believe the disinflationary dynamics of recent decades remain entrenched. No one can be sure what patterns of spending, work, living arrangements and travel will emerge over the years ahead, but it looks increasingly likely the pandemic will permanently reshape the economic landscape.

It seems odd to consider only two future scenarios, one being the disinflationary status quo, the other a re-run of the 1970s. We expect neither.

Hardwired to the inevitability of low inflation

The deflation machine bred dynamics within financial markets ideally suited to long-term investment performance: robust global growth, sustained declines in nominal and real interest rates; lower macroeconomic volatility; and a negative correlation between risky assets and government bonds, especially during market drawdowns. The death of inflation risk played a starring role, granting long-duration ‘risk-free’ debt the ideal hedging characteristics for portfolio diversification.

After more than a decade of interest rates close to 0% and the heavy footprint of central banks in government bond markets, the financial ecosystem has become wired to the inevitability of low inflation and depressed nominal interest rates.

Reset required

It seems odd to consider only two future scenarios, one being the disinflationary status quo, the other a re-run of the 1970s. We expect neither.

Far more than was the case in the early 1970s, the financial system is anchored to the belief inflation risk is dormant. Moreover, given how far nominal interest rates have fallen and how stretched asset valuations now appear, the dangers of a reset in market fundamentals to a regime of higher, more volatile inflation look that much greater.

 

A more detailed version of this article is available.

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London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussmann
75008 Paris, France