This article first appeared in the Telegraph
This might seem like a strange time to be worrying about rising prices. Smarter people than I think the biggest problem we face at the moment is not too much inflation but too little. Central banks around the world are getting ready to prime the pumps once again - America’s interest rate hikes are over; the rest of us never even got started.
The Federal Reserve is almost certain to cut interest rates on Wednesday, and the only question is whether they do so by a quarter or half of one per cent. Jay Powell, the Fed’s chairman, is concerned that America is turning Japanese economically and has told Congress he is committed to reaching his 2% inflation target. Last week, the ECB’s outgoing chief, Mario Draghi, had another ‘whatever it takes’ moment, promising to let prices rip for a while if necessary to end Europe’s economic stagnation.
It’s not hard to make a case for cutting rates. Business confidence around the world is flagging; job creation in the US, although higher than required to satisfy new entrants to the labour force, is slowing; corporate profit growth is heading the wrong way; US rail freight volumes have been declining all year; more than two thirds of finance directors expect a recession in 2020; the bond market is pointing that way too.
To reverse monetary policy as everyone expects this week, however, will be to disregard an equally long list of reasons not to cut. These include: a 50-year low in the unemployment rate at 3.7%; more job vacancies than people looking for work, suggesting wage inflation to come; strong retail spending, underpinning the 70% of the US economy focused on the consumer; and a stock-market flirting with all-time highs.
Inflation is certainly not a problem for the Fed right now. The headline rate of 1.6% is safely below target. Perhaps Mr Powell is right to worry that too little, too late risks America following the Japanese template of long-term stagnation and a central bank ineffectively ‘pushing on a string’. Precautionary rate cuts in the 1990s were successful in prolonging the economic and stock market cycle. President Trump, for one, is counting on them doing so again.
A less widely-entertained possibility, however, is that central banks around the world have been suckered into mistaking a cyclical absence of demand for a structural change in the inflation outlook. To understand whether that is so, it is worth looking at what has driven price growth lower over the past 40 years or so.
Two forces have combined to create the kind of downward pressure on inflation that the world last experienced in the 19th century as technological innovation opened up the world, lowered manufacturing costs and flooded consumer markets with stuff we never even knew we wanted.
The first phase of the more recent disinflation was caused by the acceleration of globalisation triggered by China’s economic reforms in the 1970s. This vastly expanded the world’s low-cost production and reduced the bargaining power of labour everywhere. The second phase was what economist Mohamed El-Erian has called the Amazon/Google/Uber effect.
Amazon reduced costs by side-stepping expensive intermediaries. Google achieved the same end by cutting the cost of search and bringing the cheapest option a click away. Uber (and disruptive new entrants in other industries) slashed the pricing power of incumbents by cutting barriers to entry and swamping markets with new suppliers.
These trends are not finished but it is reasonable to think that the lion’s share of their contribution to the world’s four-decade-long disinflation may be reducing. This is particularly so because the shift in power from labour to capital that globalisation and technology have fuelled carries within itself the seeds of its own reversal.
The rise of populist politics is a direct response to the alienation and anger felt by the left-behind majority about rising inequality of wealth and opportunity. Populism is essentially inflationary because it encourages higher government spending, borrowing and a curbing of the power of capitalists relative to workers. The inflation of the 1970s was triggered by higher spending on the Vietnam war and an explosion of the Federal deficit. It’s worth noting, in that context, that the US Federal budget shortfall in 2019 is forecast to be twice what was expected two and a half years ago when President Trump entered the White House.
Another feature of populist politics - the erection of protectionist barriers to free trade - is also inflationary. Tariffs and other measures designed to fragment economic and financial relationships will inevitably force prices higher. The growing pricing power of national or regional winners in a more siloed world will have the same effect.
It might seem premature to worry about inflation today, but then it always does in the moment of blissful ignorance when no-one thinks there is anything to be concerned about. Inflation often arrives quickly and devastatingly and the biggest damage to an investor’s portfolio is often sustained in the first phase of rapidly rising and unexpected inflation.
Between 1972 and 1973, inflation doubled from 3% to 6%. It doubled again the next year. During those two years the S&P 500 fell by more than 40%. In the late 1970s, despite inflation being even higher, the stock market was already looking towards the solution and was rising again. It paid to worry early then, and it might today.
The time to position yourself for a return of inflation is when people think you are a bit flaky to even mention it. This is when it’s cheap to protect yourself with inflation-linked bonds, well-managed companies with pricing power, or gold. You won’t regret doing so. As Warren Buffett once said: ‘inflation is a far more devastating tax than anything that has been enacted by our legislatures. It has a fantastic ability to simply consume capital.’
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