Andrew Milligan says central banks are paying little attention to the impact of cyclical and structural changes in modern economies.
Three months ago, I wrote about the implications of a continued low inflation world. I concluded that "headline inflation is less important than core inflation to central banks, so much more evidence of wage pressure is required to re-assess the situation". Since then, not only have wage pressures not been seen, but the realisation is growing that other structural factors may restrain core inflation.
Although headline inflation will wax and wane with volatile food and energy costs, core inflation is driven by the domestic cost structure, relying especially on trends in wages growth and therefore unit labour costs. While unemployment rates for major economies, such as Germany, Japan, the UK and USA, have been falling steadily, wages growth remains muted, keeping core inflation under control.
There are cyclical reasons why inflationary pressures may be more contained at this point in the cycle. For example, unemployment remains high in many parts of Europe. In a single market, this spare capacity will bear down on wages or pricing power. Meanwhile, other data suggests disinflationary forces are still emanating from Asian companies.
Central bankers are not paying much attention to such issues; instead they insist that temporary factors hold back wages and so, as the cycle matures, inflationary pressures will inevitably build up. The sharp reaction in European bond markets to Draghi's signal that tapering needs to end shows some investors are concerned a policy mistake may be coming.
In addition to cyclical factors, more attention should be paid to a series of structural headwinds. One example is the rise of online spending as price comparison websites become increasingly sophisticated and wide ranging. Recent sharp declines in US retail stock prices show how investors now realise the damage this can cause. Also, the impact of cloud investing on reducing company IT costs, or how technology can reduce supply chains across borders.
Last, but not least, significant developments are taking place in labour markets. The relationship between employment and wages looks to be altering in many countries. Changes in wage negotiation processes and the rise of the 'gig' economy alter the balance of power between worker, contractor, self-employed and manager.
Of course, should inflation pick up noticeably in coming months, the market will need to adjust. At the time of writing, only one further rate hike by the Fed by end-2018 has been priced in, while the FOMC has hinted at four. Under this scenario, the yield curve should steepen, the dollar recovers and assets, such as financial stocks, should outperform.
However, if inflation continues to surprise to the downside, there are considerable implications for financial assets. If lack of inflationary pressures means the business cycle lasts even longer, then long-term assets such as real estate might be seen as more attractive, so too long-duration equities. If central banks only move rates moderately higher, high-yielding emerging market debt looks more interesting, and perhaps parts of high-yield corporate bonds. Investors would also revisit valuations of high-dividend paying companies.
The more central bankers use inflation-based arguments as justification for altering monetary policy, the greater the risk that they will find barriers to act. One solution might be to use other arguments, say that easy credit and excess liquidity are causing too many problems in terms of rising asset prices or restraining politicians from taking more fiscal action. Otherwise a fork in the road looks increasingly likely, with investors needing to decide whether cyclical and structural changes in modern economies begin to rewrite the relationship between inflation, central bank policy-making and markets.
Andrew Milligan is head of global strategy at Standard Life Investments
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