Consumer price inflation in the Group of Seven (G7) major countries has been trendless over the last decade despite the upheavals in the economy and financial markets. Fluctuations in headline inflation have largely reflected movements in food and energy prices – see first chart. “Core” inflation was seemingly little affected by the credit boom and bust, and has since returned to a “normal” level by recent standards.
The post-crisis stability of core inflation has defied the predictions of both Keynesian “output gapologists” and monetary base inflationists. The gapologists claimed that the “great recession” had created large-scale spare capacity that would exert strong downward pressure on inflation, perhaps even causing prices to fall. The monetary base adherents, by contrast, argued that central bank “money-printing” on a large scale would, by the law of supply and demand, result in significantly higher inflation after 1-2 years. The failure of these forecasts is discussed later.
A very long-term perspective is provided by the Kondratyev or long cycle in inflation. There is evidence extending at least back to the 18th century that price pressures reach a major peak every 50 or so years – second chart. The cycle shows up in the price level before World War 2 and inflation thereafter, the change, presumably, reflecting the transition to a pure fiat monetary system. The last major global inflation peak occurred in the mid 1970s, suggesting that – based on its average 54-year length – the cycle bottomed in the early 2000s and is now in another upswing phase that will reach a crescendo in the mid to late 2020s.
Tony Plummer, the author of Forecasting Financial Markets, has analysed the Kondratyev cycle in detail, decomposing its upswings and downswings into a series of shorter-term cycles. According to Mr. Plummer, the cycle template implies that inflation will rise over 2014-16 but fall back again later in the 2010s. The surge to the next Kondratyev peak in the mid to late 2020s is scheduled to begin only after 2019. This would be consistent with the last three cycles, in which prices / inflation have taken off only in the final decade of the upswing – second chart.
Returning to recent performance, forecasts that inflation would fall significantly in the wake of the great recession were based partly on estimates produced by the OECD and other bodies suggesting a large shortfall of output relative to supply capacity. Core inflation seemed to display a strong relationship with such output gap estimates before the crisis, rising or falling depending on whether the deviation was positive or negative – third chart. This relationship, however, broke down in 2011, with inflation picking up despite claimed large-scale excess capacity.
The view here is that G7 output is currently broadly aligned with supply capacity – there is no significant negative output gap. The estimates produced by the OECD and others are little more than statistical guesswork, based on extrapolating the long-term trend in output. They neglect changes to demand patterns and relative costs that have rendered some capacity uneconomic. The Austrian view, in other words, is correct – part of the growth of the 2020s represented a temporary expansion of output due to demand and supply distortions created by the credit bubble. This temporary rise has now reversed.
The proposition that the output gap is negligible is supported by business survey evidence. The fourth chart compares the OECD’s estimate of the US gap with a weighted average of manufacturing and non-manufacturing operating rates from the ISM’s semi-annual survey. A correlation before the great recession has broken down, with the ISM survey suggesting that operating rates have been close to normal since late 2011.
The fifth chart shows a similar presentation for the UK, using data from the British Chambers of Commerce survey on the percentages of manufacturing and services firms working at full capacity. The suggestion is that the true UK output gap is now positive, while the gap turned negative only briefly in 2009-10.
The gapologists, of course, are undaunted by their forecasting failure, making only minor revisions to their gap estimates while claiming that the disinflationary impact has been temporarily delayed by commodity price shocks and slow reallocation of unused labour and capital due to a shortage of credit.
Similar intransigence is displayed by adherents of the view, particularly popular among gold investors, that large-scale monetary base expansion due to US / UK / Japanese QE and ECB “liquidity operations” would by now have pushed inflation significantly higher. This view has proved wrong for the simple reason that there has been very limited pass-through from the monetary base to the narrow money supply (i.e. physical cash in circulation plus instant-access bank deposits) and even less to broad money (which additionally includes time deposits, savings accounts and money market funds) – sixth chart.
A key point is that the reserves created by central banks to finance QE and lending to banking systems are not part of the “money supply”, in the sense of the stock of liquidity held by households and firms. This stock increases if the central bank actions induce commercial banks, in aggregate, to expand their balance sheets* – the money supply mostly consists of commercial bank liabilities, which rise and fall in line with assets. In practice, QE has resulted in banks substituting central bank reserves for holdings of government securities and private sector lending. The boost to the aggregate balance sheet – and so to the money supply – has, therefore, been small. This explains why QE has been so disappointing in terms of its impact on the economy, as well having little effect on inflation. (This is not to argue that QE has been unimportant in other respects – it has facilitated the financing of large budget deficits while artificially lowering long-term bond yields and inflating equity and property valuations by suppressing the discount rate used to value future earnings.)
While the claimed causal link between the monetary base and inflation has been disproved, the traditional “monetarist” relationship between the money supply itself and price pressures remains intact. According to the Friedmanite rule, inflation fluctuations follow those in money supply growth with a long and variable lag averaging about two years. The seventh chart attempts to pair turning points in G7 inflation and narrow money growth over the last 25 years. There is clear evidence in favour of the rule, when interpreted directionally and with allowance for lag variability. The relationship, moreover, has survived the great recession.
The eighth chart shows the same data over a shorter period and with a two-year lag applied to money growth. The Friedmanite relationship predicted both the fall in inflation into 2010 and the subsequent rebound that confounded the gapologists. It suggests that inflation is about to embark on another short-term upswing, consistent with Mr. Plummer’s forecast based on his analysis of the internal structure of the Kondratyev wave.
The final chart shows the relationship of inflation and house prices. A rise in money growth typically boosts financial and property markets before flowing through to higher goods and services inflation. House price developments, therefore, may provide early warning of future inflation trends. The chart applies an 18-month lag on house price changes; the suggestion, again, is that inflation will rise in 2014.
To sum up, the monetarist relationship, cycle analysis and house price developments point to a rise in inflation in 2014-15. The opposing view that excess capacity will bear down on price pressures ignores supply-side weaknesses and is inconsistent with survey evidence. The coming inflation rise is unlikely to be the start of a multi-year surge; inflation may fall again after 2015 in response to another economic downswing. The long cycle suggests a 1970s-style inflation crisis in the 2020s, a scenario for which the foundations are arguably being laid by an ongoing rise in government debt and a shift in monetary policy priorities from price stability to unemployment targeting.
*Assuming no change in non-money liabilities.
Services turnover figures for July and August suggest that GDP rose by about 1% in the third quarter – a preliminary official estimate will be released on 25 October.
Annual growth in turnover value was 11.0% in July / August combined, up from 10.0% in the second quarter. This suggests that the quarterly increase in services output volume last quarter at least matched that a year earlier, in the third quarter of 2012. The latter rise was 1.0%, partly reflecting the Olympics boost.
A 1.0% rise in services output would contribute 0.8 percentage points (pp) to quarterly GDP growth. Output data for industry and construction for July / August are consistent with the two sectors adding about 0.2 pp, for a GDP gain of 1.0%.
Such growth would be above the consensus estimate of 0.8% but would be consistent with the strength of recent business surveys and labour market data. It is, of course, possible that the Office for National Statistics will issue a lower preliminary number that is subsequently revised up.
The MSCI World equity index closed yesterday at a new post-crisis high and is only 5.7% below the all-time peak reached in October 2007*. Recent solid performance is consistent with two investment rules followed here.
The first rule, discussed in numerous posts in recent years, switches between global equities and US dollar cash depending on whether the annual growth rate of the G7 real narrow money supply is above or below that of industrial output. The motivation is that “excess” money growth is usually associated with asset price inflation. This rule outperformed buying-and-holding equities by 3.6% per annum between 1969 and 2012. G7 real money growth is currently still above output expansion but the two series are converging, raising the possibility of another “turn defensive” signal within the next 12 months – see first chart.
The second rule, discussed in a post in May, switches between equities and cash depending on whether
the G7 longer leading indicator followed here is above or below its long-run average. The indicator is derived from the OECD’s country leading indices and is designed to predict turning points in six-month industrial output growth. A cross of the indicator below the long-run average suggests sub-trend economic growth (or worse) – equities underperform cash on average during such episodes. This rule outperformed buying-and-holding equities by 5.3% per annum between 1969 and 2012. The second chart compares the cumulative return with that of the excess money investment rule.
These returns are hypothetical because they are based on currently-available data. This is less of a problem for the excess money rule – annual real money and industrial output growth could have been calculated in real time and subsequent data revisions would probably have made little difference to the timing of cross-over signals. By contrast, the leading indicator series incorporates changes over the years in the construction and constituents of the OECD’s country leading indices. Data revisions to these indices, moreover, are sometimes significant. The historical return of the leading indicator rule, therefore, is unlikely to have been achievable in practice.
The G7 longer leading indicator was above its long-run average in August but has fallen since May – third chart.
Both investment rules, therefore, currently still favour equities over cash but, if recent trends are sustained, may issue warning signals over the next 12 months. The rules, it should be noted, are designed to capture the bulk of gains during market upswings while limiting losses during downswings – they rarely mark the exact top of a bull run or bottom of a bear market.
*US dollar index. The return index including reinvested dividends is 11.4% above the October 2007 peak.
UK consumer price inflation was unchanged at 2.7% in September, while the “core” rate monitored here – which excludes energy, unprocessed food and undergraduate tuition fees – edged up from 2.0% to 2.1%. Headline inflation is forecast to moderate near term, averaging about 2.5% over the next six months, before rebounding to more than 3% later in 2014 in lagged response to faster monetary expansion in 2012-13 and associated economic strength – see first chart.
The expected near-term decline, despite another hike in household energy tariffs, reflects lower petrol costs, a likely slowdown in food inflation and an assumed dampening impact on other import prices from recent sterling appreciation. The rise in energy tariffs will be similar to last year so will have limited impact on headline inflation. An easing of food pressures, meanwhile, is suggested by recent declines in output price and input cost inflation in food manufacturing.
The forecast that inflation will trend higher during 2014 and early 2015 reflects the two-year leading relationship between monetary expansion and core price pressures – see previous post for more details. It incorporates a judgement that there is limited effective economic slack, so that solid growth will generate capacity strains and lift corporate pricing power. This is supported by the third-quarter British Chambers of Commerce survey released last week, showing that the proportions of firms in services and manufacturing working at full capacity are normal and high respectively – second chart.
Former MPC member David Blanchflower has accused the author of this journal of “crying wolf again” by forecasting that inflation will rise in 2014-15. The consistent view here in recent years has been that the stance of monetary policy was incompatible with returning inflation to the 2% target; this judgement has proved correct. The last forecast of a major inflation upswing was made in autumn 2010, ahead of a surge in the headline CPI rate to a peak of 5.2% in September 2011*.
*The forecast was that inflation would average 3.9% in 2011, which compared with Bank of England and consensus projections at the time of 2.8% and 2.6% respectively. The outturn was 4.5%.
Chinese September money numbers cast doubt on hopes that the economy is regaining momentum.
Six-month growth rates of real M1 and M2 fell last month and have declined significantly since spring 2013, towards levels reached during the 2011-12 “hard landing” scare – see chart. This suggests that economic expansion will slow in late 2013 / early 2014 unless exports pick up on the back of stronger global activity.
Six-month real money growth, moreover, is below that of industrial output, based on an August number for the latter*. There appears, in other words, to be no “excess” liquidity available to boost asset prices.
The fall in real money expansion in September partly reflected a food-driven rise in inflation – likely to reinforce an official bias against further monetary policy easing at present.
*A September figure is due this week.