As we described in Part 1, investor concern over where the inflation rate might be heading has intensified. Google searches for “inflation” are at a record high, and the price of puppies and trampolines has rocketed during lockdown. However it is not just the changing cost of goods and services that will impact the inflation rate. We also need to pay attention to structural stories that will have a longer-term influence.
It is now widely recognised that a positive demographic pulse had a downward influence on inflation rates during the period from 1990 to 2020. A recent book by Goodhart and Pradham* suggests that a reversal of that downward influence might be imminent.
Inflation rates consistently surprised to the downside between 1990 and 2020, and central banks undershot their inflation targets. Economists who had grown up in the 1970s, when wage/price spirals were at their most pernicious, were looking for a wage/price effect in the 2000s that did not appear. They were caught out by the fact that local labour markets were influenced by global labour market dynamics.
Goodhart and Pradham describe the growth of the global workforce in the 30 years from 1990 to 2020 as the “single largest labour market supply boost in history”. It began with the emergence and availability of the Eastern European workforce in the 1990s and gained considerable momentum when China joined the World Trade Organisation in 2001. As this global workforce grew the liberalisation of trade allowed manufacturing companies to shift production to low wage geographies. Labour markets for manufactured goods became global and ceased to be local. Wage pricing power went in the same direction, and Chinese workers started to have an important influence on global wage developments.
Source: Tabula and ASR
The authors describe this as a global demographic sweet spot that had a dampening influence on global wages (especially in manufacturing industries), moderating both consumer price inflation and interest rates. Their data suggests that in 2000 wages in China were at a 1:35 ratio relative to the US. With this disparity, there can have been little surprise that outsourcing production from the US to China looked like an attractive proposition. Over time, China has transitioned into a middle-income nation, and the wage advantage is now closer to 1:5. The wages argument for outsourcing has weakened and, at the same time, political pushback against globalisation and in favour of re-shoring (to the home nation) has grown stronger.
The demographic sweet spot turns sour
Not only has the demographic sweet spot has now passed, but the effect could even go into reverse. The Chinese working age population has already peaked and will shrink at an even faster rate than in western nations, partly due to the lagged effect of the one child policy of the late 20th century.
Chart 5: Working age population has peaked
Source: Tabula and UN, March 2021
Not all nations will see their working age populations shrink. India and the African nations still have helpful demographics, but there are doubts whether they can repeat the effect on global wages that we saw from China. Africa is a continent of over 50 competing nations, which uses multiple languages, and has limited labour mobility. It doesn’t look as though it will be able to imitate China 2001-2020.
India looks a better bet at being able to replicate the China because it is a single nation. However, India’s political structure and democratic systems will probably not lend themselves to a repeat of the single-minded state led model of economic development deployed with vigour by China. Migration from African nations and India could help address the shrinking working age populations in high income countries, but the current political climate in the receiving nations doesn’t suggest that this will be a likely outcome.
Robotics and automation may be able to mitigate some of the effects of shrinking working age populations, but will not fully offset. Similarly, delayed retirement might slow the pace at which working age populations shrink – but recent evidence suggests that some elderly workers are instead (pushed by the pandemic?) accelerating their move into retirement. In the US in 2020 2.4 million workers decided to retire compared to 0.8 million in 2019. To the extent that these discouraged workers have made a decision that is permanent, this represents a shrinkage in the labour force and supports the argument that wage pricing power could make a comeback for US workers.
Demographics don’t usually play a role in investors’ considerations of where the inflation rate might go, because financial market forecasts are usually limited to a 2 year rather than 2 decade horizon, and fluctuations in the price of oil, food (and trampolines and gym memberships) will have a more immediate impact on the numbers. However, the experience of forecasters during the 1990-2020 period would argue that ignoring long term structural forces was a mistake.
There will be more twists and turns ahead
It looks as though the long running trend of stability in inflation rates is ending, and that we need to buckle up for more twists and turns on the inflation roller coaster.
The shift in the Fed policy target in 2020 was a significant event. Recent comments from Fed Governor Powell were unequivocal. Powell has clarified that the Fed will err on the side of allowing inflation rates to overshoot before enacting interest rate increases that might damage employment prospects. Incidentally, we should not ignore the fact that an inflation overshoot will ensure that the real value of swollen government debt will be eroded. A convenient outcome for governments perhaps? And one which might mean that Central Banks would not be criticized for allowing an overshoot to occur.
Linked to this issue, some commentators have expressed concern that central bank independence might be a casualty of the crisis, as finance ministries and central banks work more closely together. To the extent that the period of central bank independence has coincided with a period of generally lower inflation outcomes, there is a concern that an erosion of independence might contribute to a period of higher inflation.
Charles Goodhart has suggested that, over a five-year horizon, there is a risk that CPI inflation in developed nations could reach 5%. Such an outcome would be of enormous significance for financial markets and a massive jolt for investors. Perhaps now is a wise time to consider hedging strategies?
*The Great Demographic Reversal, by Charles Goodhart and Manoj Pradhan, 2020