Is Low Inflation Here to Stay?

Ahead of this morning’s UK inflation report, Morningstar’s Bob Johnson looks at demographic trends in the US that suggest inflation will be muted long term

Robert Johnson, CFA 15 August, 2017 | 9:29AM
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US inflation has now been below expectations for six months in a row, suggesting issues in the Federal Reserve's efforts to raise inflation rates closer to 2%. Indeed, the annualised month-to-month inflation rate has been under the Fed's 2% target for five consecutive months. There have been a lot of odd quirks that have pressured inflation rates in the monthly data since March but it seems that all of these quirks wouldn't keep popping up each month if inflation were really marching toward the 2% target.

Most economists, including us, had assumed that inflation would be quite a bit higher by now, perhaps up in the 2.5%–3% range instead of 1.6% rate we saw in July. We currently aren't even expecting that headline inflation to get back over 2% until May.

Many economists, including Fed Chair Janet Yellen, are rushing to use "quirks" such as falling hotel prices to explain the below-target inflation rates. If it were just one or two items they could be a plausible explanation. With new quirks popping up each month, we aren't so quick to dismiss all of them as special. Instead, it suggests to us that inflation remains relatively tame and that the inflation we are seeing is more sector-specific supply and demand issues rather than broad inflation with the pricing of everything going up at the same time.

US CPI inflation

Demographic Factors Limiting Price Rises

An ageing population tends to buy fewer things and less food, potentially keeping a lid on the demand side for goods. However, services inflation, especially healthcare, could pressure inflation on the upside. Offsetting that, retirees, especially younger, more mobile retirees, tend to have more time to comparison shop, potentially providing another governor on prices. And suddenly new retirees may find money more valuable than time.

While I am certainly not claiming any direct relationship, inflation peaked in 2008, about the same time the first baby boomer retired and has been surprisingly tame ever since. Greater energy efficiency may pressure energy prices downward for some time. Fiscal spending on the state and local levels of government also remains under extremely tight control.

Balancing everything out, over the next five to 10 years, we believe that inflation will likely end up in the 2%–2.5% range, higher than the current 1.6%, but certainly not a 1970s-like inflation free-fall when demographics, fiscal and monetary policies, output constraints, and commodity inflation all conspired to push inflation up and over a 15% rate.

Demographics and slower productivity have combined to keep GDP growth lower than normal. The growth in the working-age population has dropped to a crawl as baby boomers retire in droves. Productivity growth has been part of the issue, too. We have focused extensively on population growth in the past, deferring discussions of productivity because of the complexity of the issue.

We have read convincing articles claiming it is a younger workforce, as a result of baby boomer retirements, that is paid less and is less productive. Others claim, equally forcefully, that greater regulation and compliance enforcement are behind the slowdown. A shift to more service-oriented businesses, which have more productivity, may also be at work. Finally, the fact that individual sectors are performing so differently isn't helping matters, either.

Industries that are growing slowly or shrinking tend to have the worst productivity numbers, employers are slow to lay off workers. Meanwhile, a lot of rapidly growing industries can't hire workers fast enough, forcing those who are there to work harder. This recovery has been characterised by the uneven nature of sector performance. If all industries were growing at the same pace, or at least close to each other, this would not be a major concern.

Maybe the overall performance since 2011 is not quite as bad as it seems. First, productivity held up incredibly well in the Great Recession. In the heat of the recession, a lot of laws were changed to give businesses more flexibility to trim labour. Despite the smaller-than-normal early recession drop, the immediate post-recession was every bit as strong as usual. That combination of a mild recession dip and normal boom made it difficult to eke out more gains later in the current recovery.

Productivity collapses in a recession as businesses cannot lay off workers fast enough. However, by mid-recession, businesses make the necessary labour cuts, causing productivity to bottom out. Then, when recovery begins, businesses are reluctant to hire new workers after just completing all those layoffs. And those who still have jobs are working extra hard to make sure they aren't the next layoff candidates.

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Robert Johnson, CFA  is director of economic analysis with Morningstar.

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