A shrinking labour force should lead to a rise in inflation, right?
Based on the law of supply and demand, one would assume that a lower labour supply should drive higher wages, which should in turn lead to higher inflation. History, however, has taught us that this is not the reality.
Empirical evidence shows that we have only had one period of significant inflation in the past and that was from the 1970s to 1980s. For over a decade the pool of available workers rose sharply by 8% every year as the post-World War II baby boomers had become of age (dotted line in chart 1). Naturally then, one would assume that wages plummeted, right? No.
Instead, the new workforce rapidly expanded their economic footprint by building their own families and buying everything that came along with it – new houses, white goods, cars etc. This surge in demand continued and caused not only CPI to rise but consequently also bond yields across the world (e.g. US bond yield represented by the brown line in chart 1).
Two types of inflation:
Consumer price inflation (CPI): the rise in the cost of consumer goods and services
Asset price inflation (API): the rise in the value of assets including property, equity, bonds, art and collectibles, crypto currencies
Maximilian Anderl is Head of Concentrated Alpha Equity and is the lead portfolio manager for the Global and European Concentrated Alpha long only and long / short strategies.
Maximilian has worked on the Concentrated Alpha team and its distinctive approach and strategies since its inception in 2004, becoming head of that team in March 2011.
On the other hand, look what happened to Japan when their workforce started to fall at the end of the millennium – a period of deflation followed. As it stands today the outlook for growth of the workforce across the G7 looks rather negative.
Chart 1: Long end sovereign yields vs. working age population
The surge in demand for goods during 1970s and 80s saw inflation and bond yields rise.
What about all this money growth (printing) that we are seeing?
Most of the recent money growth is a direct result of policy responses to COVID-19. China was the first one in and was also the first one out, so money growth there has normalised. In Europe growth in the M2 money supply has already peaked and is expected to normalise over the coming quarters. Eventually we believe money growth in the US will too.
Chart 2: Normalisation of money supply – China and Eurozone
Money growth has normalized in China post COVID but peaked in Europe and is now expected to normalise in the coming quarters.
Can quantitative easing (QE) contribute to inflation?
It is clear that QE has not been successful in creating CPI especially over the last decade. However, it has been very effective in creating API. This is mainly because central banks buy bonds from investors who in turn buy financial assets instead of spending the money on capital expenditure and consumer goods. Even so, looking beyond the last decade at over 30 years the correlation between CPI and money in circulation has always been relatively weak.
Chart 3: US Core CPI vs. money supply (YoY %)
Correlation between inflation and money has been weak
How does Modern Monetary Theory (MMT) come into play?
In our view MMT, which stipulates that governments can spend freely as long as they have the freedom to print money, has a greater potential to lead to price increases. This is because it would mean that firstly, the government competes against the private sector in terms of demand for goods or secondly, the government “pays back” taxes to citizens in the form of grants which gives them more money to spend on goods. This is currently happening in the US where inventories are being depleted and prices of goods such as commodities and used cars are being driven up due to supply shortages.
However, we see two issues with this. Firstly, households will not actually be much better off if the extra money they receive has to be spent on more expensive goods. Secondly, the increase in demand creates the need to rebuild inventories. By the time inventory levels are back up the government payments to citizens would have likely ceased, thus resulting in too much inventories and consequently a lower CPI.
So if not for the above factors, why then, is inflation on the rise?
With little choice for consumers but to stay at home during the pandemic, spending habits shifted to online, which drove up the consumption of goods while the consumption of services lagged. As economies reopen we would expect consumption patterns to normalise.
Chart 4: COVID-19 produced a durable goods super cycle
Consumption patterns are expected to normalise after seeing consumption goods rise but consumption of services lag during the pandemic.
Frankly, it seems like we have forgotten some good old lessons: the allocation of resources by governments can neither be as desirable nor as efficient than that of the private sector. In order for inflation to be sustained more and more stimulus is needed at an accelerating rate. On top of this year-on-year comparisons will only become more challenging from here. While we have certainly seen a sharp rise in inflation, it remains far from certain if inflation is here to stay. Historic evidence would suggest it will fall back to more moderate levels of 1-2% globally.
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