Four key forces should support low inflation for years to come

Inflation in the US and other countries has been high lately, raising the question of whether the low inflation era we have experienced since the 1990s is over. Central bankers and many economists argue that the current high level of inflation is transitory, and mainly due to the pandemic. As economies closed parts of their services sectors and supported incomes through fiscal policy, demand for goods became very strong. Supply was not able to catch up, blocked by COVID-related disruptions to production. But inflation has been surprising to the upside, challenging the belief in the transitory story. Where do we go from here?

Despite upside surprises, inflation data in the US have so far been consistent with the tensions associated with a reopening economy. In the US, much of the increase in headline inflation can be explained by items such as used cars and travel services, for which there is strong pent-up demand and supply has not caught up fast enough. Economic reopening is taking time and has not been without its frictions. As time passes, we believe supply will catch up and demand may also cool as consumers resume a normal level of activity. After this volatile period of strong pent-up demand and supply bottlenecks due to the reopening, we believe the structural forces that kept inflation low for decades will resume and drive inflation trends going forward.

Structural forces have kept inflation low over the past few decades

Low inflation is a global story. Inflation has been remarkably low and stable over the past three decades in the developed economies and many emerging market economies, though there are exceptions. What are the theories that attempt to explain this? Given the somewhat high inflation numbers we are observing in the US and some other countries, should we expect a change in inflation trends in the coming years, and even worry about high inflation?

There are several hypotheses that attempt to explain the long period of low and stable inflation in developed markets. The most prominent of these include the roles of globalization, technology, demographics and successful monetary policy.

One of the explanations for low inflation is the impact of globalization. While globalization was not new, it accelerated in the 1990s with the collapse of the Soviet Union in 1989 and integration of China into the world economy. This allowed production, especially in manufacturing, to move to low-wage, low-cost regions, reducing price pressures. The rise of global supply chains turbocharged this process. One concern is that globalization has peaked and may even be reversed, becoming an inflationary force. However, this is not showing up in the data. Globalization in goods, for example, has lost momentum, but it doesn’t seem to have reversed. Figure 1 suggests that economic globalization has moved roughly sideways since the global financial crisis, but not reversed. Many firms are still exposed to intense global competition, limiting their pricing power. A good case in point is the US, where tariffs on China, (where a large share of US imports originate), were raised substantially. Hundreds of billions of dollars worth of goods from China have been subject to a 25% tariff since the beginning of the tariff wars, which has not been reversed. Inflation did not rise, and actually fell during the two years after the tariffs were imposed (Figure 2).

Technology is another factor that has kept inflation low. Technology has reduced price pressures through its dampening effect on labor costs by raising productivity gains, or because of the threat that machines or software could replace workers, keeping wage growth muted. But there are other factors at play. Retail shopping, for example, is increasingly moving online, which is often cheaper and more convenient than brick and mortar stores. Online shopping has also made price comparisons easier, leading to price convergence and limiting firms’ pricing power. Such benefits are wellknown in retail but relevant in services too. Online shopping makes price comparisons easier in travel services, insurance prices, and many other services.

Aging populations are another force keeping inflation low. Workers in the aggregate produce more than they consume, creating a surplus. Dependents, i.e., children and retirees, on the other hand, consume more than they produce. A decline in the dependency ratio leads to muted demand and higher savings, constraining inflation, which has been the case in developed markets in recent decades. Some commentators argue that this trend is now becoming inflationary, as societies age and dependents grow faster than the number of workers. That may be a relevant risk down the road but evidence suggests that countries have not yet reached that demographic tipping point. Japan, which has one of the world’s oldest populations, has had 3 very low inflation since the 1990s, with no change in sight. Other countries may also have a long timeline before their low inflation conditions reverse. For example, supply of labor can be quite elastic when the labor market runs hot. Japan has increased its labor supply in recent years by improving its worker participation rate and relaxing constraints on immigration.

Finally, successful monetary policy has been another factor in low and stable inflation. After the inflationary 1970s, central banks adopted new monetary frameworks with an increased focus on price stability. These new frameworks became very successful, keeping inflation near targets. As a result, wage and price setting behavior and inflation expectations have been anchored close to central banks’ inflation targets, reinforcing price stability. There is generally broad political support for these monetary frameworks and independent central banks, meaning commitment to price stability will likely continue in the years to come. 

Conclusion 

The bottom line is that the forces that have kept inflation low over the past few decades are likely to remain forceful, keeping inflation low in the coming years. It is true that some of these forces can wane in the long run, but major reversals are not in sight and unlikely to happen rapidly. Meanwhile other forces that keep inflation low, such as technology and monetary policy are here to stay. Therefore, we expect the low inflation trends of recent decades to remain intact through our investment horizon. In fact, the challenge for global central banks is to push against such disinflationary trends and avoid undershooting their inflation targets. The new frameworks adopted by the US Federal Reserve and the European Central Bank aim to do just that.