Understanding inflation

After our recent series on the challenges facing central banks, we continue to get questions about why, when there is so much else for them to worry about and so much of the financial system which is not as much under their control as they might wish, they have such an ongoing concern about inflation.

Inflation is, in both most developed countries and an increasingly large number of emerging economies, at extremely low levels. (The UK is a bit of an outlier here among developed nations, but even after sterling’s significant post-referendum fall, inflation in Britain is in historical terms very moderate – in living memory it has been some 10 times higher than the current 3% level).  Moreover it seems stable at these low levels, to the point at which price rises are no longer something the man in the street is worried about.

This has long been the ambition of central bankers:  to reduce inflation not just to very low levels, but more importantly to something that is simply not a matter of daily concern or even comment for the ordinary citizen.   So why, with this finally achieved, do they not sit back and accept that inflation was yesterday’s battle and has been conclusively won?

This is to misunderstand central bankers’ concern.  It is not so much that they want inflation to return, as that they want to understand why it is absent.  This is partly driven by the desire to understand how all aspects of the economy work and fit together – most senior central bankers retain an academic’s interest in their world and how it works.  But it is more driven by the fear that if they do not understand why inflation is absent now, they will not know what lies behind any unexpected return to inflation and be ill-placed to counter it.

Let us very simply restate their problem.  The current global economic expansion is one of the longest on record, and unemployment has fallen sharply in many countries.  Indeed in much of the developed world, GDP is at all time highs and unemployment is back at levels it has not seen for 50 years, since the post war boom period of the 1950s and 1960s.  But, contrary to economic theory and all economists’ expectations, this has led to neither wage inflation nor general price inflation.

It seems that neither businesses nor labour have any pricing power, any ability to make price rises stick, despite the global economy running at a good pace and labour markets in many countries being tight.  And this suggests that something fundamental has happened to change the relationships at the heart of the economy between activity and inflation.

The inverse relationship between unemployment and inflation was first formally identified by William Phillips, whose seminal paper published in 1958 established the relationship and introduced the concept of the Phillips curve to describe it.  To be sure, previous generations of economists had observed that prices tended to rise in boom times and fall in recessions, but the causality was assumed to work through the pricing power of producers (ie, companies would raise their prices when demand for their products was strong and lower them when it was weak), and the strength of the relationship was anyway variable.  Phillips highlighted the role of labour and wages as well;  the stronger (and more unionised) labour forces of the post-war era gave more prominence to wage-driven inflation.

But the relationships that Phillips derived appear to have broken down.  In seeking to understand this, therefore, it is sensible to look at changes in the labour market.  And here, there is much for commentators to consider.

One such commentator is Gary Smith, of Barings (an asset management firm), who has produced a most interesting chart “Influences on the Phillips Curve” (click to download).  The chart shows the various influences on today’s labour market, and as he observes, there are at least three factors in play:  direct changes in the workplace and the relationships between worker and employer, the impact of globalisation and new technology, and demographic changes in society generally.  As the chart shows, all three of these have the overall effect of dampening labour’s ability to pursue wage increases and therefore the level of wage inflation in the economy.

To take the last of the three first, demographics, increased life expectancy and better health are enabling and encouraging older workers to stay in the labour market for longer.  This helps them to keep occupied and to deal with the financial implications of longevity.  They are also motivated in part because low interest rates are reducing their income from savings and pensions, especially annuities.  Many people, especially those in defined contribution schemes, have retired with lower pensions than they expected.

As a result, many workers are delaying full retirement. However, by doing so, they nudge the lifetime savings and spending balance (ie, they save for longer and postpone the moment where they start drawing on savings), and this extra desire to save places further downward pressure on interest rates.  The question arises as to whether this pressure to work for longer will ever be alleviated.

This “greying” of the workforce also directly impacts the balance of power between labour and capital.  The most aggressive wage demands typically emanate from young workers.  This is partly because they have greater need (to finance growing families), but also because they are more likely to change jobs if dissatisfied (and changing jobs is a common way to get a wage rise).  But the share of such workers in the labour market is falling, and older workers are less aggressive wage negotiators.

In addition, in many countries union membership has fallen. Andy Haldane, chief economist of the Bank of England, identified that around 6 million employees in the UK are members of trade unions today, compared with 13 million (out of a considerably smaller overall workforce) in the late 1970s.  Collective wage negotiations are less common and individual agreements have become more widespread.  This has helped dampen wage inflation.

This shift towards individual wage negotiations reflects changes in the labour market, in particular the increase in self-employment and part-time working.  Partly, this is yet another result of the demographic influences we noted earlier:  observations suggest that as they get older, workers tend to prefer to be self-employed; this means that as the share of older workers in the labour market increases, the number of self-employed workers is also likely to rise.  They are a key component of the “marginal worker” count, often viewed as critical in determining the outcome of wage negotiations.

Another factor though is without doubt the growth of the gig economy, as we observed in our article “Inequality, and the Licence Economy”, 11.12.16.   The gig economy is characterised by the prevalence of short-term contracts and freelance work, which has created uncertainty and a weak bargaining position for many workers.

Finally, there is the role of technology and globalisation.  Technology is increasingly creating a “winner takes all” economy, where there is one dominant company in any given sector, and globalisation is increasingly resulting in that company, and so its profits, not even being in the same country as the workforce it employs.

Economists are still grappling to understand all the consequences of these various changes.   But it is clear that, taken together, they all weaken the bargaining power of workers, reduce the incentives for wage negotiation, lead to a decline in labour’s share of profits and put yet more downward pressure on wage inflation.

Given that there are so many reasons for weak wage inflation that would have been unknown to William Phillips in 1958, it is probably not surprising that his explanation of the trade-off between unemployment and inflation appears to have broken down.   The consequences for ordinary workers are stagnating wages and a sense that the division of spoils in the economy is increasingly unfairly weighted against the average person.

For central banks, this has two implications.   In the short run, the lack of wage inflation may impede interest rate normalisation in coming quarters, which may in turn reduce their policy manoeuvrability when the next recession hits.  “Lower for longer” might become “lower forever”, with the implication being that the starting point for interest rates when the next recession starts will be very low, and perhaps too low to offer them adequate room for manoeuvre.

More seriously, if the link between unemployment and inflation is broken – more precisely, if the direct consequence of tightening monetary policy, ie a slower economy and higher unemployment, does not lead to the desired consequence of lower inflation – then society, which is anyway becoming much more questioning of the decisions of the elite, may come to query the legitimacy of central banks causing the pain of unemployment for no gain in terms of lower inflation.

It is this twin prospect of a tight monetary policy – currently their main weapon against inflation – being (a) ineffective and (b) politically unacceptable that concerns central bankers.  The hunt is on for an answer, for a new theory to explain inflation.