Weight never changes
On Wednesday, at 8:30AM, the Bureau of Labor Statistics will release the October CPI report. In theory, it should be one of the highly anticipated economic events of the month. After all, low and steady inflation has been the foundation of historic rallies in both the bond and stock markets.
For the record, the key number to watch is core CPI, that is, consumer prices excluding food and energy. That statistic will, most likely, come in up 0.2% month-over-month and up 2.4% year-over-year. This should translate to a core consumption deflator reading of up 1.7% year-over-year for October, still a little below the Fed’s 2% target.
But when the CPI report comes out, it will probably be met with yawns. The truth is, American inflation has been in a low and steady corridor for a generation. Since January of 1996, the year-over-year core CPI inflation rate has never been above 3.0%. Nor, for all the worry about deflation, has it ever fallen below 0.6%.
This begs a three important questions:
- Why hasn’t inflation been higher?
- Why hasn’t inflation been lower? and
- Will inflation ever break out of its benign corridor?
On the first question, the most important reasons for low inflation are greater competition and a lack of aggregate demand.
The increase in competition reflects, to some extent, rising international trade and diminished unionization. In 1970, the sum of nominal exports and imports equaled 11% of U.S. GDP. By 2011, that had risen to 31%, (although it has since fallen back to 26%, reflecting, in part, the impact of the trade war). Global competition from cheaper overseas suppliers has undoubtedly restrained both U.S. prices and wages. In addition, in 1983, over 20% of American workers were members of unions. In 2018 that number had fallen to 10.5% and this has also likely reduced cost pressure on American businesses.
However, a more pervasive (though less measurable) trend has been the impact of information technology on consumer prices. On-line pricing makes it very easy for consumers and businesses to identify the cheapest deal available. For consumers this has lowered the cost of taking out a mortgage, buying a car, booking airline travel or buying a new shirt. For businesses, it has reduced the cost of stocking the shelves. This has had a crushing effect on prices in any industry where buyers have genuine choices and can see what they are buying.
A second inflation sedative has been a lack of aggregate demand. In theory, the production of goods and services generates the income used to buy them. In economics this is called the circular flow of income. However, rising inequality in recent decades has meant that an increasing share of income has ended up in the hands of the richest American households, who have a greater-than-average propensity to save, rather than spend, income. This has simultaneously funneled money towards financial assets and away from consumer goods and services, contributing to dramatic gains in stock and bond prices in a low-inflation, low growth economy.
Given all of this, however, it is also worth asking why core CPI inflation has not turned negative?
Part of the answer may, of course be, timely policy responses to economic downturns. In each of the last three recessions, the Federal Government has countered economic weakness through fiscal stimulus measures such as extended unemployment benefits and lower income tax withholding. In addition, with the exception of a short period during the last downturn, the risk of a prolonged depression has always seemed low, discouraging sellers from dramatic price reductions. And, as Fed officials have often pointed out, inflation expectations tend to be sticky and feed back to drive overall inflation. If you expect inflation of 2% over the next year, you may well raise your prices by 2%.
However, the single biggest protection against negative inflation is probably sticky wages. Despite multiple recessions, including two very big ones in the early 1980s and the late 2000s, the wages of production and non-supervisory workers have always posted a year-over-year gain. While some industries can see sharp cuts in bonuses from time to time, it is very hard for management to tell workers that their base pay is being cut or for workers to accept such a possibility.
Wage growth does dip in the aftermath of recession, as businesses take advantage of a weak job market and fell to just 1.2% year-over-year in October 2012. However, it has not gone negative over at least the 55 years for which we have good monthly data. This helps hold inflation positive in two ways. First, it contributes to an increase in costs for businesses which they try to pass on to their customers. Second, it provides income to consumers broadly, fueling the demand for goods and services.
Finally, is there anything that could cause inflation to break out of its corridor?
Despite central bank worries, it is hard to see a short-term path to outright deflation. Wage growth for production and non-supervisory workers in October was 3.5% year-over-year and, with relatively low productivity growth, this should feed through to higher prices for goods and particularly services. A sharp rise in the dollar or an outright global recession could lead to some imported deflation. However, trade tensions appear to be waning rather than rising which should, in time, lead to a lower dollar and stronger growth overseas.
Nor, in a slow-growing U.S. economy, does rising inflation appear to be an immediate threat. However, it is worth noting that, while competitive trends are likely irreversible, forces impacting aggregate demand could potentially change. In particular, big increases in government spending or lower taxes on lower and middle-income consumers could boost aggregate demand, leading to some inflation.
Moreover, if inflation did begin to rise more quickly, huge holdings of currency and cash in short-term accounts by both households and businesses could act as an accelerant. In periods of high inflation in the past, both in the U.S. and overseas, prices have actually grown faster than the money supply, as consumers, worried about money losing value, tried to spend it at an accelerated pace. If this were to occur, the significant inflation that America has avoided for a generation could finally return.
On Wednesday, Jay Powell will testify to Congress on the state of the economy and he will likely, once again, characterize inflation as low and stable. In the short run, it is likely to remain so. As the season of Christmas cake and mince pies approaches, we need to remind ourselves that it is possible to put on more than a few pounds. And, in the long run, both investors and policy makers would do well to remember that inflation can still rise as well as fall.
