- The global economy is undergoing broadly synchronized reflation. The U.S. economy is currently in the lower or middle portion of the inflationary spectrum, while inflation is running well below central bank targets outside the U.S.
- How far will reflation go? What does it mean for markets? Our baseline outlook calls for a gradual rise in U.S. inflation in the coming years, influenced by the pull of labor markets and the possibility that a more cloistered U.S. trade policy will push up prices.
- We view the possibility of extreme inflation or deflation as remote and find little reason to worry that a wage-price dynamic will spiral out of control. We anticipate support for the dollar around current levels and do not expect large distortions from oil prices.
- For investors, inflation’s recovery implies a supportive environment for risk assets insofar as its initial stages are positive for corporate earnings and creditworthiness. Our outlook also suggests continued upward pressure on the market pricing of inflation.
FORECASTING THE PATH OF GLOBAL REFLATION1
Around the globe, a synchronized upturn in nominal growth is underway, including an upturn in inflation. Global monetary policy is responding in kind. The Federal Reserve (Fed) is increasingly confident that inflation will hit its target rate and has begun accelerating its cautious rate-tightening cycle; the pendulum is gradually swinging toward tightening at other developed market (DM) central banks.
The investing community’s perception of inflation risk has swung during the current expansion from fear of an inflationary surge after the Great Recession to fear of global deflation when oil prices collapsed and, since last year, back to a reflation theme, again accompanied by worries that some economies, particularly the U.S., could overshoot their central banks’ targets. By contrast, throughout these periods, inflation itself (at least excluding volatile energy and food prices) has displayed surprising stability.
In this paper, we ask: How far will reflation go in the U.S. and other developed market economies? How can we forecast inflation? We conclude with our forecast and what it means for investors.
WHAT DO WE KNOW ABOUT INFLATION?
- It is fairly stable and anchored. While the market’s pricing of inflation has swayed, core inflation itself has been rather stable (excluding energy and food). What underpins that inertia? It is the anchoring of inflation expectations intact since the Fed’s vigilant inflation fighting in the early 1980s and the resulting increase in the credibility of central banks.
- It is slow moving, and deflation is a rare outcome. Monetary policy discussions often focus on whether central banks have fallen “behind the curve,” suggesting runaway inflation poses a serious risk. Yet inflation moves slowly (EXHIBIT 1). Shocks one year rarely persist the next year, in either direction. And year-over-year deflation almost never occurs, across countries and history. (The U.S. has never recorded it since beginning the core inflation series in the 1950s.)
- It is not very cyclical. Since the 1980s, inflation in the U.S. and other developed economies has not displayed a strong connection to the business cycle and, in particular, has not consistently moved higher as expansions have progressed. Reality thus has run somewhat counter to the typical “mental model” of an overheating economy toward the end of the cycle.
Core inflation generally moves slowly
EXHIBIT 1: U.S. YEAR/YEAR INFLATION ANNUAL ACCELERATION (PPT)
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1 This note is a distillation of the research paper “Inflation’s Next Phase” by Michael Hood and Ben Mandel (2017).
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