Mercer's David Scobie says inflation may be lying low at the moment - but it is lurking

By David Scobie*

Polaroids, floppy disks, Walkmans and phone books. There is an entire generation today for whom these items are mostly alien - consigned to the past thanks to the wisdom and technology of our age. Is global inflation such a quaint relic?

With only one of the last 35 calendar years exhibiting inflation of above 5% in the US (and New Zealand’s recent experience also subdued), one could be forgiven for thinking so. Or perhaps it is a dormant creature waiting for its moment to pounce – a scenario gathering some credence as certain commodities show price strength and the US 10 Year Treasury Note nudges a 3% yield.

This article assesses the broad inflationary forces at work and concludes that, rather than assuming a continuation of the recent past, investors would do well to ensure their portfolios are “fit for purpose” under a variety of future inflation scenarios. 

Opposing forces

For some observers, the runaway levels of inflation observed in the 1970s and 1980s are unequivocally a problem of the past. To this way of thinking, a combination of central bank independence, structural reductions in the strength of organised labour, decreasing reliance on fossil fuels and improvements in technology that lower consumer prices, makes inflation more controllable by policymakers and essentially caged. 

At the other end of the spectrum are those who argue that inflation is almost inevitable as unemployment reaches secular lows in the major developed countries, reversals in demographic trends increase dependency ratios in coming decades, and central bank policy remains extremely stimulative in a historical context.

Inflation is a complex phenomenon driven by many interacting forces within an economy, and some of these relationships are not well understood. Consequently, Mercer is cautious about making bold predictions about the level or direction of inflation over time.

We do believe, however, that there is evidence that the balance of inflationary and disinflationary forces is shifting, such that there are an increasing number of plausible scenarios in which inflation could move meaningfully higher than current levels in developed economies.

Peak globalisation

Inflation and wages – and by extension the labour market – are intertwined.  For the last few decades, the increasing globalisation of the labour market has acted as a disinflationary force as it has opened up cheaper labour markets in emerging economies. This has reduced the bargaining power of workers in developed economies and exerted downward pressure on both salaries and prices.

The influence of this relationship may wane as previous sources of cheap labour in Asia, Latin America and Eastern Europe experience rising wages and standards of living, and the options for low-cost labour outsourcing diminish.

Although there may be scope for further trade liberalisation to drive production costs down globally, there is perhaps a greater chance of moves in the opposite direction (deglobalisation) given the current tensions surrounding international trading relationships.

Fewer workers, more retirees

Another inflation driver with a long-term trend that may be changing direction is global demographics – in particular, the proportion of the total population that is working versus the proportion not working (known as the dependency ratio).

There is a lively debate around how changes in the dependency ratio may affect interest rates and inflation, but a compelling argument centres on the supply and demand for goods and services.

The argument is that children and retirees (the dependent population) contribute only to the demand for goods (via consumption), while the working-age population contributes to both the demand and supply of goods (via consumption and production).

The dependent population, therefore, provide an inflationary impulse in the economy, while the working-age population will tend to be a disinflationary force.

United Nations population projections suggest that we are at, or close to, a turning point in the global dependency ratio. This could turn a longstanding disinflationary force into an inflationary one over time.

Cyclical pressures

In addition to the structural drivers discussed so far, a further inflationary impulse arises from cyclical pressures in the current economic environment.

Although low unemployment and strong global growth can, to some extent, be offset by tightening monetary policy, cyclical forces are arguably more inflationary today than at any time since the Global Financial Crisis. This is particularly true in the US, where fiscal stimulus is being applied via tax cuts and expenditure when the economy is already facing late-cycle inflationary pressures.

In counterpoint to the dynamics highlighted above, it is worth noting that technology is likely to remain a powerful disinflationary influence for decades to come, as the prospect of rapid increases in automation places downward pressure on wages and production costs.

Managing the risks

The discussion above illustrates that the balance of inflationary and disinflationary forces in the global economy may be changing, and arguably inflation risks are skewed toward the upside from a cyclical standpoint.

When assessing their portfolios, investors should take care to avoid biasing allocations in a way that assumes a continuation of past trends. In practice, this entails investors making a clear assessment of how exposed they are to higher-inflation scenarios.

Inflation-sensitive investors holding portfolios dominated by broad market equity and fixed interest bonds could consider diversifying both their growth and defensive allocations.

Within growth portfolios, real assets such as commodities, property and infrastructure – both listed and unlisted – may provide some degree of inflation protection.

Within defensive portfolios, inflation swaps, inflation-linked bonds, shorter-duration bonds and floating-rate assets are likely to prove more robust under higher-inflation scenarios than traditional fixed interest government and corporate bonds.

Whether the inflation “beast” will rear its head is a story still unfolding; yet, like all threats to investment outcomes, it is a risk best prepared for.   


*David Scobie is a Principal in Mercer’s Investments business, based in Auckland.  He advises institutional clients on their investment policies, structures and fund manager selection, linking in with Mercer's global research capability. 

This article does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.

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32 Comments

Inflation is dead - it was killed by the overzealous RB & a persistent high OCR.
Wages & inflation have disconnected.
Price fixing by monopolies and corporates is the new game - Local body rates, electricity, Govt charges, petrol, building supplies, etc all price setters regardless of consumer demand or wage growth/flattening.
Would banks want to test the servicing limits of their recent home loan borrowers?
Interest rates unlikely to rise (much).

Couple of things;

- The OCR is Low not high
- Wage growth and inflation are both low not moving in opposite directions
- Banks do test the servicing limits of all not just recent home lone borrowers (that's the whole business model for them)

Friendly suggestion, maybe put just a little thought/research into your posts

I think you need to read and understand Mortgagebelt is talking historic cause, not today's state. of course I could be wrong also but for me its past tense not present.

"Inflation is dead" = present tense

Inflation died = pasted tense

If they are referring to prior historic events they need to articulate better. The onus is not on the rest of us to guess what they "actually mean".

'it was killed by the overzealous RB & a persistent high OCR"
would you like to apply the same sarcasm to "was" & "is"?

Agreed. The RBNZ arrived too late, did too much and stayed too long. Seeing as how this period was 2007/8 prior to the GFC you could rephrase it slightly, and then end up in past historic tense.

As stated above. Tense wasn't the problem with that sentence. Learn grammar or read better =)

"Inflation is dead - it [WAS] killed by"

you do understand "WAS" is a past tense right?

hahahaha touchy much?

"Banks do test the servicing limits of all not just recent home lone borrowers" = banks always seeking, and finding, maximum extractive value. So much economic theory completely misses the nature of this extraction from the economy, or the compounding nature of debt. This article is no different.

"If the Phillips curve, the inflation rate and loan growth don’t explain the push for higher interest rates, what does? The answer was suggested in an April 12th Bloomberg article by Yalman Onaran, titled “Surging LIBOR, Once a Red Flag, Is Now a Cash Machine for Banks.” He wrote:

The largest U.S. lenders could each make at least $1 billion in additional pretax profit in 2018 from a jump in the London interbank offered rate for dollars, based on data disclosed by the companies. That’s because customers who take out loans are forced to pay more as Libor rises while the banks’ own cost of credit has mostly held steady."

https://ellenbrown.com/2018/04/22/fox-in-the-hen-house-why-interest-rate...

I think we have a philosophical problem with financial types. ie most seem to be inherently Austrians in nature and no balance with Keynesian / Minsky outlook until forced to on pain of death.

"Surging libor" sure its climbing, hardly surging. If you look at the graph,

https://www.bloomberg.com/news/articles/2018-04-12/surging-libor-once-a-...

Look back at 2008 when it was high then surged fast.

Better graph,

https://www.homefinance.nl/english/international-interest-rates/libor/us...

showing the libor rate was historically a lot higher. So can someone explian this history for me? or is it how it sort of looks, much to do about nothing.

Not just banks, just about everything tries to get the maximum extractive value no matter what the damage to the economy overall. Hence why Government's play such an important part in an economy, they are meant to catch the Enron's of this world and jail them.

Our problem is becoming who watches the watchers? its meant to be the voter, who of which 45%+ are easily bought off with 30 pieces of silver.

While I 100% agree inflation is dead I dont agree on the cause. For me what killed our economy and in turn inflation is / was peak oil in July 2008 at $148US a barrel.

Of course its not that simplistic, we have huge financial gambling and excesses wedded to a "grow for ever economy" which stopped growing.

I agree on price fixing very much even if its not on purpose (ie rates) in some cases. The result is the monopolies are killing the areas where real growth of an economy comes from.

Then there is growing inequality....an economy does best when all ppl participate, if only the top 1~10% are doing (very) well, well they cant support growth, not enough of them.

So energy that costs too much, inadequate demand and parasitic behaviour all add up to no/little genuine growth and I see it getting worse not better myself, so yes inflation is dead.

Answering your last sentence, if this report is anyways credible & accurate there will be trouble ahead and Bankers and other manipulators may discover just how brutal the payback is -
https://www.zerohedge.com/news/2018-04-30/new-type-poverty-crushing-midd...

From zero hedge no less...

I think it is correct if only generally. That is I see that everyone/thing is attempting the maximise the returns and this is really noticeable when there is un-fair leverage. One thing though taking on so much debt is semi-optional if you can stand ignore the peer /neighbour's pressure of not "keeping up with the Jones's"

I am now debt free, the reduced stress and non-grind feeling is just great however took me a decade to do it.

You say that inflation is dead but most of our costs can be set at will regardless of affordability. Is your argument that there is a conspiracy among price setters to keep increases low in order to control inflation? Or do you simultaneously believe that inflation can't happen/isn't happening even while significant areas of the economy are increasing prices at will?

Japan has tried everything and despite a very aged population, low unemployment, very loose monetary policy and massive deficits inflation just fails to appear. I think they admit defeat now. As for nz households, well we are all paying off debt. No massive inflationary spending splurges are likely with debt already so high. Government spending isn't going to take off. Can't see more money chasing same amount of goods any time soon.

Having an ageing population is also deflationary, so there are two opposing forces at work there. Which will also be true of Western economies as more boomers retire and live out that retirement.

Also, could you please say a bit more on your statement that Kiwi's are deleveraging? I know that debt has come down by a few fractions of a decimal but couldn't that simply be related to the rate of house price growth slowing rather than Kiwi's paying off debt? What leads you to think that they are now deleveraging?

Mortgagebelt & cs, I don't necessarily disagree with you both but what if I played devil's advocte and said:
- petrol prices rising
- minimum wages rising significantly in NZ
- large government spending programme
will all lead to increased inflation in NZ?

Your thoughts?

Possibly increased inflation - especially if the larger wage rounds are successful.
I still dont see any buoyant consumer led demand driving up prices.

5% for a sub-set of employees isnt significant IMHO. What is going to be interesting is if skilled public workers like teachers/nurses etc get 5%+.

Petrol prices rising doesnt matter when you still only have the same amount in your pocket, it means deflation elsewhere, result a net zero.

I do think there is a wish to raise prices just the in-ability to do so as too many ppl cant pay.

I subscribe to the MMT view on inflation. Inflation is not "always and everywhere a monetary phenomenon". It is a "spending more than the real capacity of your economy to increase output problem" - which explains the observable world - including hyperinflations like Weimar and Zimbabwe and low inflation despite big deficits and massive QE in countries like Japan- better than the standard fare.
Are we close to "spending more than the real capacity of our economy"? No. Not with the labour underutilisation statistics we have and cheap immigrant labour. So no wage price spiral likely. Do you actually remember the last time we had a wage price spiral???? Not in my lifetime..
Is there any chance of a massive increase in spending anywhere to be seen? Government? No - committed to surpluses (taxing our more than it spends). Households? Not really, they can't sustain more debt and private sector credit growth is subdued in NZ. Business aren't going to borrow and invest much given lack of demand. Big export boom that employs all our underemployed labour?
Most of the forces are deflationary and they have been for a long time. And in light of that, if anything I would suspect interest rates might go down - not that it will do much good because no-ones borrowing just cause the money's cheap.
Remember how many times we've been told that inflation is about to escape out of the cracks in the ground and engulf us all since the GFC ( I love how they use words like "lurking" - mild inflation a "monster")? Well, personally, I can't see it happening.

Rejoice everyone - inflation has been vanquished. Aren't we all so much better off???

Thanks for your insighful reply cs : )

I have been reading the Epsilon blog this weekend and Ben Hunt sees a flaw in how wage rises are calculated in America, and that actually the rate of wage inflation in the US is running higher than the markets think, (at around 3%). Plus using AI to analyse economic media sources showing inflation rising in the perceived sentiment.

Either way, if inflation is returning elsewhere in the globe, I wonder if NZ might be slower to respond? Because the higher interest rates (if they eventuate) would be negative for such a huge amount of mortgage debt and reverse the wealth effect?

http://epsilontheory.com/the-narrative-giveth-and-the-narrative-taketh-a...

Inflation requires a number of things to occur, mainly availability of cash in hand or borrowing ability both of which depend on a sufficiency of discretionary disposable income. The main inflationary increases have been in Govt charges, non trade ables and food so if such increases exceed growth of discretionary income no inflation and perhaps deflation. Furthermore should a global Banking crisis emerge then Banks may/will not have sufficient money to lend and without this asset purchases are more likely to decline in value than increase. Deutsch Bank Europe's largest Bank has an exposure to derivatives 15 time the size of Germany's GDP and have just effectively sacked the CEO after 4 years of losses and a decrease in share price of 96%. The outlook is gloomy and no sign of a white knight to save what is the Global economy so the endgame will be interesting and possibly nasty if history does repeat itself.

Rising underlying costs meets flat-lining consumer affordability (its a surplus energy equation). You simply cant keep adding to the tab if your net wage is decreasing...
Result; Cost increases but no inflation. Any cost increases effectively hamstring demand.
Only the entities that can pass the cost on (eg Councils, monopolys)

At some point costs negate any profit on enough companies /sectors and they cease to be ie go out of business and that costs jobs. I am left wondering how long this game can go on. It has managed to stagger on for a decade, another decade?

yes i agree. How long can the system be fudged... The big problem is a sufficient quantity of jobs paying well enough to keep the (world) economy afloat... otherwise demand and prices fall ... costing jobs.
Govts will increasingly step in with big deficit spending to hold things together ... basically Capitalism is morphing into socialism. Marx was right. Capitalism eventually eats itself.

I think the role technology in the short term will have on inflation is really hard to predict. It mas be huge or a lot less than people are predicting.
On one hand you could say that technological advances are accelerating and having such a huge effect on efficiency that it will be very large lever reducing costs.
But on the other hand you could also say that many of the low hanging fruit as far as suddenly bringing prices down ( Ie Air bnb , uba. ) have all ready been picked and will now happen less frequently. These always have the quality of harnessing un-tapped capacity and can have sudden knee jerk like effects on price. Much harder feats like synthetic meats or electric cars take a lot more than just producing an app so wont have such a quick dramatic effect on price, but rather can only be phased in over time.

I have read this article carefully .... and found it utterly Useless. Nowhere does the author attempt to quantify his assertions on the Possibility that Higher inflation may be coming along Sometime in the future.
If that represents the quality of advice given to clients,i am surprised he has any left.Personally,it would suit me fine to see interest rate rises,but when and by how much? Since inflation rates started falling Decades ago,i do not expect to see any significant rise in inflation for many years ahead.

Yes you're right. It seems a bit devoid of supporting data. Actually seems devoid of logic too. Take this statement for example

The argument is that children and retirees (the dependent population) contribute only to the demand for goods (via consumption), while the working-age population contributes to both the demand and supply of goods (via consumption and production).

Plausible? The argument seems to ignore the more important fact that consumption is a function of age. Beyond about fifty, the older people get the less they consume until they become ultra frugal old codgers complaining all the time about how expensive things have become.