Strategic Fixed Income: Inflation – Is That It?

 In Market and Investment Insights

John Pattullo, Co-Head of Strategic Fixed Income, discusses the range of factors he believes indicate that current inflation is more cyclical than structural.

Key Takeaways

  • The hype on inflation continues to impact the markets, yet the Strategic Fixed Income Team believes a structural breakout is unlikely in the near future; if anything, they see a greater likelihood of inflation falling.
  • If there were to be a structural breakout in inflation, they believe 2018 had the perfect ingredients for it.
  • Still, policymakers are hampered in the task of bringing inflation back to target levels by their strict adherence to old, traditional economics.

John Pattullo: 2018 was really a reflationary year driven by Chinese expansion a couple of years ago, the Trump tax cuts, equity markets have been strong, activity’s been strong, money supply was growing. And we never really had any breakout in inflation, even though that was the big thing the market feared.

In fact, my colleague, Jenna, did a video in February really talking about the hysteria of inflation. And inflation expectations did rise a little bit in the spring. They peaked out in May and they’ve really fallen quite a lot subsequently and we think they’ll fall even more going forward, not least because the oil price has come off very significantly. So that’s kind of interesting.

And the way we see the world is very much one of secular stagnation as in there’s not enough growth and demand in the world really to purchase output. We think there’s plenty of output and activity and capacity to fill the demand that is generally a lot lower than it has been in previous economic cycles.

In addition, we think the world’s turning quite Japanese. There’s too much debt in the world. Technology is eroding pricing power and the effects of Amazon and the Amazonation of the world is all quite deflationary.

So we’ve printed almost $12 trillion worth of QE but we haven’t had any CPI core inflation or consumer price inflation. What we have had, of course, is asset price inflation and that has been quite inequitable for many concerned.

I think the policy makers are a bit confused due to this puzzle of inflation. They don’t really understand why inflation hasn’t broken out. And I think the problem is they’re using the wrong set of economic textbooks. They’re using very conventional economics, which looks at the Phillips curve relationship, output gaps, they kind of assume there’s one person working in one factory making one tangible product and that’s not really the world we live in any longer. We live in a gig economy, a transparent world. Most of us work in services industries in a very global economy without trade unions and not making tangible products.

So if you were a computer game manufacturer, for example, you could invent that on your computer, you could sell 10 million, you could sell 100 million. You wouldn’t be capacity constrained. And I think all those sort of things would suggest that conventional economics doesn’t really give a good explanation for why this puzzle-works inflation hasn’t happened.

So the way we see the world is one where you’ve had some cyclical inflation, so there has been an up-tip in the activity and a small up-tick in inflation. That’s no surprise to us and we said that. But you haven’t seen a structural breakout with inflation or inflation expectations. Primarily, because there’s not enough demand in the economy to push up prices.

Generally, demand pull inflation is whereby there’s too much demand for the amount of output the economy can make so invariably, prices would get pulled up. We don’t really see that in the world. If anything, there’s too much capacity, there’s too much transparency really for companies to be able to pull prices up. So in that environment, you wouldn’t really expect much inflation and we don’t think there’s much inflation from the demand pull side currently today.

The other sort of inflation you get is cost push inflation and I think some commentators get a little bit confused here. So cost push inflation is inflation which goes up because the cost of things goes up and, typically, it might be through wages, it might be through the oil price, it might be through the depreciation of sterling in the UK or other countries whose currency has gone down. It costs more to import or indeed, it might be a kind of a tax like inflation of health care costs. If health care costs go up, it essentially works as a tax on us. We have less cash in our pocket after we’ve paid for our healthcare. So there’s some confusion between the first one, demand pull, as in too much activity, and cost push inflation.

Now having said all of that, there has been some wage inflation and we completely concede that. So workers, especially in America, are slightly hard to get and there has been a little bit of wage and pressure going on. There’s also been some minimum wage legislation in the UK and in some states in America which made basically hiring workers cost more. But the key point I want to make today is really the extra cost of wages as it gets pushed onto final cost inflation or goods price inflation, the traditional model would suggest if you’re short of workers, you’ve got to pay them more. If you’ve got to pay them more, you would then automatically pull the price of what you’re selling up.

But with the transparency of the Internet, the Uberization of the world, if you like, the Amazonation of the world, it’s very hard to put the input cost straight onto your output costs because it’s so competitive out there. And there’s plenty of capacity already installed around the world making whatever you want to talk about.

So that’s the missing link between some modest wage inflation not getting pushed into output price inflation or goods price inflation. So there’s a whole host of factors which hopefully I’ve explained quite well, which would suggest inflation, in our opinion, is much more cyclical. We don’t expect any structural breakout inflation. And if there was going to be a structural breakout of inflation, an inflation expectation is 2018 was the pivot year.

If anything, we’re actually more concerned about inflation falling away. Headline inflation would certainly fall away with the weaker oil price. Core inflation, we think, will remain fairly muted and tame as it has been for many years and probably will continue to be so.

Thank you very much for listening.

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Quantitative Easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market.
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