Economists and financial analysts around the world are scratching their heads about why inflation remains so low, despite the recent upturn in the US economy and most other countries in the developed world.
For over a century, we have been schooled to think that when the economy and consumer spending are rising, prices should move higher – at times significantly higher depending on the strength of the upturn. If prices move too much higher, this is viewed as a threat to the economy.
For most of the 20th century, inflation was considered the critical threat to economic stability in the US, Europe and much of the world. The US Federal Reserve Bank was created in 1913 specifically to manage this risk.
Remember that the Fed (whoever is at the helm) continually reminds us that its “dual mandate” is to maximize employment and stabilize prices. Never mind that the Fed has only limited ability to do either.
For the last several years, the Fed has maintained a core forecast that US inflation would move back to its target of at least 2% as measured by its favorite inflation indicator (see below). Yet the fact is, inflation has consistently remained below the Fed’s 2% target. The question is, why? More on that as we go along today.
The widely-followed Consumer Price Index rose only 1.9% for the 12 months ended August. Excluding food and energy, the CPI rose only 1.7% over the last 12 months. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures Index (PCE), rose only 1.43% for the year ended August. Core PCE, minus food and energy, rose only 1.29% in the last 12 months.
Again, the question is, why are the leading barometers of inflation consistently falling behind the Fed’s estimates? Here’s a theory I am increasingly coming to embrace:
What if the combined and continuing effects of technology and a globalized market of goods and labor are so altering commerce and prices that the 20th century script is as outmoded as the IBM Selectric typewriter I used to type these letters on back in the late 1970s and 1980s?
The world has changed in ways we may not completely grasp. With the mind-boggling advances in technology we’ve witnessed in the last few decades, it may well be that increased productivity has bottled-up inflation, perhaps indefinitely.
Let me be clear, the absence of higher inflation doesn’t mean that everyone can afford basic necessities such as food, housing, healthcare, etc. Prices are still rising, albeit more slowly, and there will always be a low-income segment of the population that struggle to make ends meet.
The point is, the rising cost of most of life’s necessities has mitigated over the past two decades due to the deflationary effects of technology. In some cases, the prices for certain goods and services have actually decreased – think computers for example.
Other goods and services may not have come down in price but offer far more value than in the past. As an example, you can get a car that uses less fuel and is far safer for less money (inflation adjusted) than a gas guzzler of yesteryear.
The savings don’t manifest just in terms of lower sticker prices. The benefit often comes in much higher quality at not much higher prices.
I’m not at all sure the Fed gets this. Which raises the question of whether or not the Fed’s intent to raise interest rates another four times in the next year or so makes sense. That’s a debate I’ll get to in the weeks and months just ahead.
For the record, I’m not suggesting that inflation of 5-6% is a thing of the past. Not at all. What I am saying is that technology is advancing so fast that inflation could remain below the Fed’s targets for some time to come. If true, that means our economic and investment assumptions may need to change on a myriad of levels just ahead.
Fed Chair Janet Yellen admitted in a speech last week that the Fed may have “misjudged” the jobs market and the recent strength of wages. That’s a rare admission for the head of the Fed.
Her acknowledgment that economic patterns, and inflation especially, are not unfolding as she and the Fed expected should be taken as a sign that the world has changed and that the Fed, and other policymakers, have not yet grasped the extent of those shifts.
Technology is rapidly changing the world as we know it and in ways we couldn’t have imagined a decade or two ago. I’ll leave it there for today. Lots to think about!