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Inflation remains transitory due to strong long-term trends

At the beginning of 2021, when Inflation Scare 1.0 hit market sentiment, we focussed more on technological innovation, automation, the materially lower level of unionised labour and the economy’s reduced reliance on oil as continuing to drive the inflation declines that were evident prior to COVID-19.

Now the market is in a FUD, or Fear, Uncertainty and Doubt. FUD relating to inflation is the concern du jour, but I believe investors have little to worry about.

Inflation orbits a number of factors

First is the possibility that central banks are not only behind the curve, but asleep at the wheel. US inflation reached 6.2% year-on-year in October 2021, much higher than the market anticipated and even higher that the US Federal Reserve’s own forecasts of 2.1% in March and its more recent 4.2% forecast, in September. The high absolute level of inflation and its rate of acceleration have triggered sincere fears of an imminent and unsettling rise in interest rates.

Second, and despite apparent surging inflation, central banks continue their various forms of quantitative easing (QE). Some commentators suggest this activity is entirely inappropriate and will lead to hyperinflation. Keeping in mind such predictions serve to sell newspaper subscriptions more readily than they serve investors, hyperinflation is rapid, excessive, and out-of-control price increases of more than 50% per month. Not likely.

And it’s worth considering Japan’s QE program, which in proportion to its economy, is many times larger than the US package. Yet, despite its very aggressive programme, Japan continues to skirt with deflation not inflation.

Finally, many investors point to the fall in employment participation rates (referred to the Great Resignation in the US), and a surge in wages in some pockets of the economy, as a sure sign inflation will continue to accelerate and force central banks to inevitably raise rates.

Investors are right to be concerned about the consequences of higher rates. Large large, accumulated levels of global debt along with continued money printing - even as inflation surges - have even reputable investors fearing Armageddon.

It is important to distinguish fears from realities, but it is equally important to accept that either can trigger a market rout.

Use a longer-term lens

A longer-term lens better serves investors because it’s arguably easier to predict. Ask me whether ARB, Reece, Macquarie Telecom or CSL will be more valuable in a decade’s time and the answer is an unequivocal yes.

However, ask me whether their share prices will be higher next month or next year and I couldn’t say. It’s a far riskier proposition to predict the short term, even for the highest quality companies.

With that in mind, we believe low inflation is structural. Take a look at inflation in the US since the 1980s and one can see clear evidence of a shift lower for rates of inflation.

US historical inflation to 2021

Source: www.macrotrends.net

Expect structural decline of inflation to continue

Since 1979, when the US record year-over-year headline inflation of 13.3%, inflation has been in structural decline. This can be attributed to a number of factors that are unlikely to change.

First, the level of unionised labour is significantly lower than it was even 30 years ago. Large, coordinated and regular claims for wage increases are a thing of the past. The oft-reported thuggish and militant behavior of some unions has done them no favours in terms of their prospects for attracting a new generation of members. Their influence and therefore the prospects for rising wage pressure from this source remains in decline.

Second, and perhaps more important, investment in technology has accelerated. And technology itself is deflationary. Automation, AI, big data, digitization, information technology ... all are deflationary. Their advance is exponential, and they democratise access, which encourages competition. Technology lowers the cost of manufacturing, delivery and servicing, raising margins without the need to raise prices.

And one particular form of technology - automation - is directly responsible for displacing labour, keeping a lid on wages growth.

These are the structural forces promoting disinflation, and they have not disappeared. It remains valid to call inflation fears 'transitory'.

There are short-term factors

In the short term, we acknowledge the impact of a lack of immigration on wages in pockets of the economy. Competition amongst employers has seen wages rise in retail, digital, resources and construction. A reopening of the borders however will reverse these pressures and Australia and the US should revert to the trends in place prior to the pandemic.

History is replete with bouts of inflation coincident with an economic recovery from recession. While the cause of each recession differs, the response is usually the same – monetary and fiscal stimulation to support the economy. As the rate of economic growth eases and normalises, so too will inflation pressures.

Perhaps more obviously, the ‘base effect’ will work in reverse. Current high rates of inflation exist simply because we are comparing prices today to those recorded during the depths of the pandemic lockdowns last year.

This time next year however, a lower rate of price acceleration will be compared to the new higher base recorded this year. The result should be disinflation. At that time, we believe the market will take a sigh of relief, FUD could morph into FOMO (fear of missing out) and investors could return to the business of investing in high-quality businesses, especially those with structural tailwinds for growth.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

 

7 Comments
Roger Montgomery
December 07, 2021

Thanks, Warren, With respect to money supply, even as US M1 and M2 Money supply has risen exponentially since the 1960s to a near-vertical rate now, US inflation has been in the doldrums for four decades.

Warren Bird
December 08, 2021

Roger, US M2 grew mostly in the 5-10% range through the 1960's until well into the 1980's, a period of fairly high inflation. It's highest annual growth rate during those years was 14% in the 1970's.

Then it slowed to less then 5% for the early 1990's before picking up to average 6-7% pa for many years.

All of that didn't create inflation of those rates because the Velocity of money slowed and productivity improvements, globalisation, etc - the things you rightly talked about - meant that more MV could turn into T growth without so quickly spilling into P growth. A lot of policy things went right for a long period of time. (In Australia we had all the reforms of the Hawke-Keating era, designed to enhance T growth and reduce P growth, taming Mr Keating's bucking bronco.)

However, M2 growth took off in 2020 to over 20% pa, peaking at 27% early in 2021 and has slowed to a rate that is still above the peak of the 1970's.

You used the term ''exponential''. A chart of the M2 stock does show a fairly steady - though not constant - climb from 1959 until 2020. But it's a fairly shallow line, not looking anywhere near 'vertical' as you claim. It goes 'vertical' in 2020.

We are talking about a quantitatively different period of money supply growth than any other in the historical period you've mentioned. Central Banks are finally waking up to what that means, as evidenced in the Fed Governor's comments this week.

(Note that personally I think M3 or Broad Money are the better measures to use, but the story isn't dissimilar.)

Peter
December 05, 2021

The risk we face isn’t inflation devaluing assets and interest rates attacking the ability to pay. The real risk is greed and accumulation of assets in the hands of a few. Democracies work better for all if the citizens believe that their participation in work and the economy rewards them justly.
Inequality leads to revolution and anarchy, and the loss of life and quality of living that entails. Unless citizens get wealthier, and jobs are available that allow a good life, expect to live in enclaves with armed guards and security protecting your family’s quality of life.
Hyperbole? It is the way of life for the rich in the Phillipines, Indonesia, Columbia and other quasi democracies where the greedy have taken all they can, and white-anting the democracy to further enrich themselves and their cohorts.

Exactly as Montgomery says, you can’t predict the short term in finance, but predicting and enabling long term investment without considering the social impact of driving down middle class income and creating a huge precariat has real risks to investments.

Roger Montgomery (author)
December 07, 2021

Indeed, as I have written in my fortnightly column in The Australian, capitalism if left to run its course puts all the wealth in the hands of a very small number of people. For that reason, it is right to regulate capitalism. Capitalism naturally produces monopolies, which left unchecked results in abuse of power. The challenge for regulators in democracies is not to hobble tech monopolies such that competitors operating in foreign autocracies gain an edge.

C
December 03, 2021

A crystal clear analysis by Warren. Thanks. The following statement is the only one I cannot agree with. “the latter is up to all the consumers and businesses in the Australian economy and what their appetite is to keep borrowing funds.” - consumers and businesses appetite is largely dependent on interest rate. As you have said yourself, to control P, all it takes is “only a very modest cash rate increase”. Personally I think it may be too late now.

Warren Bird
December 03, 2021

C, if there was a simplistic one-for-one link between interest rates and consumer/business behaviour then monetary policy would be a lot easier! Sadly, it isn't so. Interest rates are an important influence, but to repeat one of my favourite metaphors about this, central banks can lead a horse to water, but whether and how much it drinks us up to the horse.

Warren Bird
December 02, 2021

Nothing Roger has said is incorrect, but in almost all discussions of the inflation outlook that I'm seeing at the moment, one key input is missing. Money supply growth.

I suspect the reason for this being overlooked is the misunderstanding of QE and the monetary transmission mechanism. When QE was first introduced during the GFC, many worried that it would cause a rise in inflation. This was because of the mistaken belief that QE was the same as ''printing money'' and thus a rise in money supply growth would trigger inflation.

That fear didn't eventuate because for many years all that QE didn't turn into money supply growth. Banks just reinvested at the Fed. The money supply only grows when banks lend, which creates money. Let me say again, QE is not money printing any more than reducing the cash rate from 5% to 0% is money printing. That's not how monetary policy works!

It seems to me that because of that post-GFC experience everyone has forgotten about money supply. And yet, in more recent years QE has indeed facilitated money supply growth as the global recovery became more robust and borrowing took off, including for housing. The horse that was led to water but didn't drink after the GFC suddenly got thirsty.

MV = PT. Can't avoid that. Growing M (money supply) can be somewhat offset by falling V (velocity of money circulation), but that is already about as low as it can go. Quite a lot of M growth can turn into real economic growth (T, for transactions, ie real GDP) at the moment because of slack in the economy and/or improving productivity (including the sort of things Roger highlights in the article). But with enough growth in M, the inevitable is a sharper rise in P (prices, i.e. inflation).

In Australia, money supply growth (whether you use M3 or Broad Money) took off in 2020, peaking in annual growth terms at 13% early this calendar year. That's the most rapid growth since the expansion that greeted Glenn Stevens when he became RBA Governor in 2006 and which he acted to stem early in his tenure. Inflation was heading higher back then - it got to 5% - but his actions brought it back into the target range and it averaged 2.35% for his decade at the helm.

Money growth has softened back a bit to around 8% since early 2021, but 7-8% is still enough to signal to me that the inflation pressure we're seeing is at least at risk of not being transitory. The only way it doesn't persist is if QE is brought to an end quickly OR the banks just put the liquidity that QE provides back with the central bank again. The former is a policy decision of the RBA, and they're moving in that direction already; the latter is up to all the consumers and businesses in the Australian economy and what their appetite is to keep borrowing funds.

The most important long term trend for inflation to decline back from wherever it gets to in 2021-22 is the focus of monetary policy on inflation targeting. All the stuff that Roger and others are talking about is true. They are factors that feed into the interplay between M, V, P and T.

But at the end of the day it's a truism that MV=PT, and the control of P depends critically on how the policy that determines M is conducted. Monetary policy is the reason that deflation didn't take hold as many feared after the GFC. It will also, hopefully, be the reason that inflation doesn't take off for a sustained period of time in the current climate. With any luck, all it will take is an end to QE and only a very modest cash rate increase, if any. We'll have to see.

 

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