Investors are assuming the “Great Moderation” remains intact. But the tectonic plates are shifting – and bode ill for long-term returns.
On 7 February, Jerome Powell, the Chairman of the Federal Reserve’s Board of Governors, summarised the challenge confronting central bankers in the U.S., Australia and elsewhere: “We have a significant road ahead to get (the Consumer Price Index’s annualised rate of increase, which policymakers, economists, journalists and investors almost invariably mislabel “inflation”) down to 2%, which is the Fed’s target. There’s been an expectation that it will (abate) quickly and painlessly. I don’t think that’s at all guaranteed.”
Accordingly, he reckons that the Fed would “probably need to do further (interest) rate increases.” Yet “there should be a significant decline in inflation this year;” moreover, it’s likely that it “would fall to around the Fed’s target next year.” Powell concluded: “it’s not going to be smooth, it’s probably going to be bumpy. The process (of restraining CPI’s annualised rate of growth) takes a lot of time.”
How much? Presently, most investors seem to expect that CPI’s rate of increase will promptly abate to central banks’ targets and remain there. What’s more, they’re assuming that, thanks to monetary central planners’ “easing” late this year or sometime next, the norm of the past 30 years – lower interest rates and higher asset prices – will return.
I suspect that they’re overly sanguine. Today’s consensus is discounting or ignoring tectonic changes – indeed, diametric reversals of crucial long-term trends – that have underpinned the era of mostly-quiescent CPI and low interest rates from 1990 to 2020 (the so-called “Great Moderation”). If as a result CPI is henceforth “stickier” than hitherto, then central banks’ policy rates must increase further and remain higher for longer than the herd expects. That, in turn, bodes ill for the prices of most financial assets including stocks.
Overconfidence and myopia provide unsound bases for investment decisions. Instead, cold data and valid logic rather than rosy expectations underpin sober analysis – as well as solid long-term investment results. And as I’ve repeatedly detailed, pride cometh before the fall (see also Why you’re probably overconfident – and what you can do about it, 14 February 2022; How low could stocks go in 2023? 14 November 2022; and How we’ve prepared for the next bust, 28 November 2022).
Has inflation peaked? That’s the question the RBA’s Governor, the federal Treasurer and many others are increasingly answering affirmatively. But it’s not obvious that they’re right, and it’s hardly the key question. The crucial ones, it seems to me, which very few people are asking, include:
- Has the “Great Moderation” weakened, or even ended?
- Perhaps for this reason, what if during the next several years CPI’s annualised rate of growth recedes but doesn’t return to central banks’ targets?
- If not, will they maintain their targets, push rates higher for longer and increase the probability, duration and severity of recession – or loosen their targets and thereby further weaken their credibility?
Plausible answers to these questions should prompt investors to reassess their convictions and stress-test their portfolios (see also Why inflation is and will remain high, 15 August 2022 and Three risks you can discount – and one you can’t, 3 December 2021).
CPI’s Course over the Past Century
Using quarterly data compiled by the U.S. Bureau of Labor Statistics, Figure 1 plots the CPI’s annualised rate of change since March 1914. Its average is 3.28% and its standard deviation is 4.97%. Accordingly, and given that these data are roughly normally distributed, approximately 95% of the observations lie within two standard deviations of the mean. Figure 1 plots its confidence interval’s lower bound (3.28% – (2 × 4.97%) = -6.7%) and upper bound (3.28% + (2 × 4.97%) = 13.2%); and although it didn’t formally exist until 2012 (an informal target has existed since the mid-1990s), it also plots the Fed’s inflation target (which, in order to match the RBA’s, I’ll assume entails a lower bound of 1% and upper bound of 3%).
During and immediately after the First World War (1917-1920), consumer price inflation almost continuously exceeded 15%. It collapsed during the Depression of 1920-1921, stabilised during the Roaring 20s, plummeted again during the Great Depression of the 1930s (at annualised rates of -9 to -11% in 1931-1933), soared again during and immediately after the Second World War (9-13% in 1941-1942 and 9-20% in 1946-1947) and Korean War (7-9% in 1951) and the 1970s and early-1980s (7-12% in 1973-1975 and 7-15% in 1978-1982). In sharp contrast, CPI’s rate of growth and degree of fluctuation was comparatively low during the 35 years from 1985 to 2020 (mean of 2.56% and standard deviation of 1.32%). Finally, and in the wake of the Global Viral Crisis, since 2021 CPI has spiked above 9% and averaged more than 7%.
Figure 1: Consumer Price Index, U.S., Annualised Rate of Change, Quarterly Data, Mar 1914-Dec 2022
What’s caused these outbreaks of consumer price inflation? In the U.S. as well as Australia (see below) and elsewhere, it’s been sudden and massive increases of government expenditure. The consequent supply chain bottlenecks have been proximate rather than ultimate factors.
These increases of government spending have been aided and abetted by the Federal Reserve. Without its connivance, these mammoth bursts of expenditure couldn’t have occurred; hence the central bank is inflation’s ultimate cause and creator. Inflation, in other words, is always an everywhere a monetary phenomenon. During the 20th century’s first half, wars usually triggered these huge increases of government spending; in the 1970s, butter rather than guns (as well as energy crises) were the culprits; most recently, the “war” against COVID-19 has been the instigator.
As many have noted, CPI’s current outburst is the worst since the 1980s. Although it’s well above the Fed’s target, by historical standards it’s not unusual. Most notably, it’s well within the 95% confidence interval.
Using data compiled by the RBA, Figure 2 plots the CPI’s annualised rate of change since June 1922. Its average is 4.02% and its standard deviation is 4.71%.
The Australian CPI’s long-term mean is higher than its American counterpart’s and its standard deviation is lower; consequently, and generally speaking, consumer price inflation has been more marked here than there.
Like their counterparts in the U.S., these data are roughly normally distributed; hence approximately 95% of the observations lie within two standard deviations of the mean. Figure 2 plots its lower bound (-5.4%) and upper bound (13.44%); and although it didn’t exist until the early-1990s, it also plots the RBA’s inflation target of 2-3% per year.
Figure 2: Consumer Price Index, Australia, Annualised Rate of Change, Quarterly Data, Jun 1922-Dec 2022
Over the past century, and largely as a consequence of America’s rising global economic and financial sway, CPI’s course in Australia has ever more closely resembled its counterpart in the U.S.:
- Since 2020, it’s risen to a 40-year high;
- From 1990 to 2020, compared to the years to 1989, its annualised rate of change was low and fluctuated little.
- During the ca. 15 years from the late-1960s to the early-1980s, it rose smartly (as much as 17.7% in the 12 months to March 1975);
- The Second World War, immediate post-war years and early-1950s (Korean War) were also periods when CPI soared. During the 12 months to December 1950, CPI’s annualised rate of increase reached its all-time maximum (23.9%).
- Some deflation occurred during the Great Depression, but was relatively mild (-4.1% in the year to December 1930).
As in the U.S., so too in Australia: sudden and massive increases of government expenditure (aided and abetted by the RBA or its predecessor, the Commonwealth Bank, which until 1959 was a de facto central bank as well as a commercial and retail bank) have caused these bursts of consumer price inflation. Finally, on only three occasions has CPI’s 12-month rate of change deviated more than two standard deviations from its mean: (1) in the early-1930s, (2) in the early-1950s and (3) in the mid-1970s. The spike since 2020, like the one in the U.S., doesn’t.
How Often and for How Long Has CPI Breached Its Current Bounds?
It’s important to emphasise: not until 2012 did the Fed adopt an explicit inflation target, but from the mid-1990s until 2012 it informally targeted a rise of consumer prices of “around 2%” per year. The figures in Table 1 substantiate this claim. CPI’s annualised rate of change has remained within the Fed’s target band during 34% of the quarters since 1990. During this interval, its mean was 2.62%; moreover, consumer price inflation has remained within this band an average of 4.9 continuous quarters (slightly more than two years).
Table 1: Average Duration (Quarters), Annualised Change of CPI Above, Within and Below Bounds, U.S., 1914-2022
Since 1990, CPI’s rate of growth has exceeded the upper bound of the Fed’s target 29% of the time; during these quarters, consumer price inflation has averaged 4.5% per year and has remained above the upper bound an average of 6.7 continuous quarters (2.25 years). Finally, CPI’s rate of growth has sunk below the lower bound 37% of the time; during these quarters, consumer price inflation has averaged 1.3% per year and has remained below the lower bound an average of 5.7 quarters (ca. 2.6 years).
During the era that the Fed first tacitly and then explicitly targeted consumer price inflation, CPI’s annualised rate of increased has remained within the Fed’s bounds barely one-third of the time. By that standard, has the policy succeeded? On the other hand, since 1990 CPI’s average rate of annualised growth has been much less volatile compared to the 75 years to 1989.
Before 1990, CPI’s annual rate of growth remained within the Fed’s current target band just 11% of the time, and exceeded the upper bound 47% of the time and fell below the lower bound 42% of the time. Moreover, CPI averaged fewer quarters (1.7) within the bounds than it has since 1990 (4.9); similarly, it has averaged more than twice as many consecutive quarters below the lower bound and above the upper bound.
Once consumer price inflation exceeds the Fed’s upper bound, how many quarters does it take to revert to target? To answer this key question, I excluded from the analysis all quarters whose annualised rate of consumer price inflation was less than 3.0%, i.e., below the Fed’s bound. I then ranked the remaining data by annualised CPI; and for each observation I computed the number of quarters that elapsed before CPI returned within bounds. Finally, I divided these data into five equal (by number of observations) groups (“quintiles”), and for each quintile computed the range of CPI’s annualised change and the average duration (number of quarters) that it required to return to the 2-3% target. Table 2 summarises the results.
Table 2: Average Number of Quarters Above-Bound CPI Requires to Return within Bounds, U.S., 1914-2022
Once consumer price inflation breaches the Fed’s upper bound, how many quarters does it take to return within its bounds? According to Table 2, the answer depends crucially upon the interval of time under consideration.
Two sets of results are paramount: first, since 1990 each quintile’s range has been markedly lower than it was until 1989; perhaps as a result, the return to bounds has taken much less time than it did until 1989. Second, since 1990 the time required has varied linearly with the extent of the breach; until 1989, the relationship was curvilinear.
Since 1990, the smaller has been the extent of CPI’s breach above the Fed’s upper bound, the more quickly it returns to the 2-3% target. And even in Quintile #1, where CPI spikes highest, it returns to target within two years (7 quarters). Before 1989, on the other hand, the relationship was strongly curvilinear and the rebounds took much longer: in Quintiles 1-2 as well as 4-5, it took an average of 13-16 quarters (3.25-4 years); in Quintile #3, on the other hand, it took 24 quarters (6 years).
Quintile #2’s range includes CPI’s recent spike to more than 9% per year. How long will it take to return to 2-3%? If the “Great Moderation” remains intact, approximately 6 quarters (18 months). That’s very similar to Jerome Powell’s estimate on 7 February. But if fundamentals have changed and the future less resembles the period since 1990 than the one to 1989, CPI’s return to the 2-3% target could take much longer.
Table 3 reproduces, with Australian data, the analysis in Table 1. The results are much the same: during the “inflation targeting” period since 1990, CPI’s rate of growth has remained within the RBA’s bounds a much greater percentage of the time (30.5%) than it did until 1989 (6.0%). Moreover, the breaches of the bounds since 1990 have been less egregious than they were until 1989: in particular since 1990 CPI’s the average rate of “above bound” CPI growth has been 4.58% (versus 7.77% before 1989); moreover, since 1990 the duration of consecutive above-bound quarters has averaged 6.4 versus 15.4 until 1989.
Table 3: Average Duration (Quarters), Annualised Change of CPI Above, Within and Below Bounds, Australia, 1922-2022
Table 4 reproduces, with Australian data, the analysis in Table 2. Although the ranges of each quintile are higher in Australia than in the U.S., the results are again largely comparable. In particular, the ranges have been tighter since 1990 than they were until 1989, and the duration (average number of quarters required to return within the 2-3% bound) has been much shorter since 1990 than it was until 1989.
There is, however, one crucial difference: before 1990 in Australia, CPI effectively didn’t revert to the 2-3% range.
Table 4: Average Number of Quarters Above-Bound CPI Requires to Return within Bounds, Australia, 1922-2022
Quintile #1’s range encompasses CPI’s recent (12 months to December 2022) spike to more than 7.8%. How long will it take to recede to 2-3%? If the era since 1990 is prologue, almost nine quarters (a bit more than two years). That’s identical to the RBA’s most recent estimates. In its latest Statement on Monetary Policy, released on 17 February, it forecasted that CPI’s annualised rate of increase has peaked and is now decelerating. It nonetheless expects that it’ll take more than two years to return to the upper bound of its target range, i.e., to 4.75% at the end of this year, 3.5% in June of next year and 3.0% in June 2025.
But if fundamentals have changed and the future less resembles the years since 1990 and more the period to 1989, Table 4 indicates that CPI’s reversion to the 2-3% target could take much longer. Hence another crucial question: will the next few years revert to the “norm” since 1990? Or will they acquire some of the attributes of the era to 1989?
In the Future, Why Might CPI’s Growth Settle Above 3% per Year?
According to the minutes of the Federal Reserve’s meeting in September, members of its Open Markets Committee and their advisers generally agreed that during the next several months the course of consumer prices was likely to exceed what they’d previously expected. That’s because “supply constraints in product and labour markets were larger and likely to be longer lasting than previously anticipated.” But the minutes also revealed a potentially fundamental divergence of opinion. Some officials were clearly anxious that inflationary pressures would become more persistent because businesses and households would expect price rises to continue. Others were more relaxed; the leap in consumer prices stemmed largely from bottlenecks – and these and other price pressures would abate as pandemic-related demand and supply imbalances eased.
This debate reflects an emerging, broader and more fundamental disagreement about the future direction of consumer prices. On the one side, most participants believe that the global economy will remain in the low-CPI and low-interest rate environment that’s prevailed over most of the past three decades. On the other side, a growing minority has become convinced that major changes are afoot: before long, central bankers could confront a world where inflationary rather than deflationary forces are ascendant.
Decelerating or Receding Globalisation
From 1990 to 2020, three epochal developments underpinned globalisation. The integration into the world economy of the former republics of the Soviet Union placed downward pressure upon the prices of many commodities; this factor, plus the entry of China and its hundreds of millions of low-wage workers into the global economy, as well as the continued rapid advance of digital and information technology, suppressed the costs of production and thus the prices of manufactured goods. In response, through a process of wage arbitrage, considerable productive capacity shifted from wealthy to developing nations. As a result, the stiff winds of the division of labour, outsourcing and technology blew forcefully in the same direction: at central banks’ backs. Hence as CPI abated they drastically eased their policy rates.
Today, in contrast, the winds are blowing in multiple directions – including central banks’ faces. “People celebrating the push for deglobalisation should be careful what they wish for,” observed The Australian Financial Review on 23 November. “A slowdown in global trade and more onshoring of manufacturing since COVID-19 will make the economy less flexible, increase costs for business, and push up prices for consumers.” Moreover, “manufacturing more onshore – as the Albanese government wants to do – will be more expensive. Australia is a high-cost economy with relatively high wages, and lacking economies of scale.” That means higher consumer prices.
The RBA’s governor, Philip Lowe, agrees. On 16 November, in a speech entitled “COVID, Our Changing Economy and Monetary Policy,” he cautioned that the “supply side” challenges facing the economy would boost prices and dent prosperity: “a slowdown in global trade because of the fallout from the pandemic and geopolitical tensions will “inevitably affect both growth in living standards and the pricing of goods and services in global markets.”
“The Great Demographic Reversal”
More than in the 1990s and 2000s, the working-age populations of most advanced nations are declining. China’s and Eastern Europe’s are also shrinking; in fact, India has overtaken China as the world’s most populous nation. Two British economists, Charles Goodhart and Manoj Pradhan, have dubbed this development the “the great demographic reversal” (for details, see The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival (Palgrave Macmillan, 2020).
From the early-1990s to 2018, the economic and financial rise of China from a low-income into a partly middle-income country (it’ll likely succumb to the “middle-income trap”), combined with a sweet spot in its demography, accelerated the growth of its GDP and abated the rise of inflation in advanced economies. The combination of these factors, according to Goodhart and Pradhan, meant that “the effective labour supply force for the world’s advanced economy trading system more than doubled … from 1991 to 2018.”
This huge expansion eroded workers’ bargaining position; it also placed downward pressure upon real wages and stagnant or falling prices, particularly for manufactured goods. “These deflationary forces have been so aggressive,” say Goodhart and Pradhan, “that they … caused inflation to remain at, or more recently below, central bank targets, … over the decades from 1990 onwards.” The financial impact of these demographic changes has been pronounced. They abetted a steady decline and cumulative collapse of interest rates. This, in turn, greatly boosted the prices of assets such as shares and houses.
But these major trends, Goodhart and Pradhan contend, are now reversing. The steady decline of birth rates is begetting a sharp deceleration of the growth of the workforce in many countries. Indeed, it’s shrinking in major economies in Asia (such as China, Japan and Korea) and Europe (the EU as a whole, and particularly in Germany, Italy and Spain).
At the same time, increased life expectancy is leading to a rapid increase in the number of retirees. Workers produce more than they consume, but dependents – children and retirees – do the opposite. Hence “the sharp worsening in the dependency ratios around the world means that dependents who consume but do not produce will outweigh the deflationary workers. The inevitable result will be (consumer price) inflation.” More than this, Goodhart and Pradhan prophesy,
“The great demographic reversal and the retreat from globalisation will bring back stronger inflationary pressures – this is our highest conviction view … The rising inflation that we foresee in the future will raise nominal interest rates. Unless (it’s) offset by a major rise in the participation rates of the elderly, growth has to be based on higher productivity per worker.” In other words, continued sluggish growth of GDP and rising inflation – namely stagflation – is the risk (see also Three risks you can discount – and one you can’t, 3 December 2021).
The Crazed Quest for “Net Zero”
Adding to the demographic challenge, Philip Lowe alleges, are “climate-induced weather shocks disrupting production of food and commodities, and interrupting the transport and logistics industries.” I strongly doubt it (see, for example, Will climate change soon make Australia “uninsurable”? 10 January 2022) but never mind: what’s unquestionably true is that, to the extent that it’s occurring, which is highly questionable (see “Global Energy Transition” – Fact or Fiction? 6 February 2022 and Decarbonisation: A doubter’s guide for conservative investors, 16 May 2022), the transition to intermittent sources of energy is colossally expensive and hugely inflationary (see also Investors beware: “Cheap” renewables are very expensive, 16 June 2022).
“In the short term,” noted the AFR on 23 November, “the surge in renewables investment is unlikely to fully offset the decline in investment in fossil fuels.”
Moreover, “to reach net zero emissions by 2050 and shut off all coal-fired power, Australia will need to build the equivalent of 50 Snowy Hydro schemes, or seven times the capacity of the National Electricity Market that has been built over the past 24 years, according to the Energy Security Board.” Even people who believe that such a frenzied pace of construction over the next 30 years is possible (I’m not one of them) must concede that it’ll be enormously expensive – and highly inflationary.
Lowe tacitly agrees: “it is difficult to make predictions here, but it’s probable that the global capital stock that is used to produce energy will come under recurring pressure in the years ahead. If so, we could expect higher and more volatile energy prices during the transition to a more renewables-based energy supply.”
“The higher energy prices in the near-term and the risk of power shortages,” the AFR concluded, “will undermine the government’s push to bring manufacturing back onshore. Overall, Lowe says the confluence of supply disruptions from the reversal in globalisation, demographics, climate change and the energy transition is likely to make inflation more variable. For central banks, this is likely to make inflation-targeting more challenging.”
Central bankers and their cheer squads in universities, mainstream media and financial markets congratulate themselves that the “Great Moderation” has been (note the use of the present perfect tense, since they expect or hope that it still exists) mostly the consequence of disciplined and sound central banking. In reality, it owed (note my use of the past tense) much to fortuitous demographic, geopolitical and technological developments. These demographic and geopolitical factors are now fading – and inflationary ones are supplanting them. Does that mean that the world will enter into another inflationary era? If so, is it imminent?
Predicting a trend’s future course is extremely difficult; discerning the eclipse of one trend by another is insuperably so. In an interview in The Financial Times on 1 June 2021, Charles Goodhart nonetheless reckoned that “the coronavirus pandemic, and the supply shock that it has induced, will mark the dividing line between the deflationary forces of the last 30-40 years and the resurgent inflation of the next two decades.”
- Precisely because major trends don’t (dis)appear suddenly, I conclude that during the next couple of years, via high (by the standards of the past decade) rates of interest and the demand destruction that it entails, central banks will likely cause CPI’s annualised rate of growth to abate towards their 2-3% target.
- But will it return within its bound and remain within it thereafter? As a consequence of demographic shifts, mild deglobalisation, ruinously costly and utterly futile attempts at decarbonise, as well as governments’ uncontrollable spending and their usual stupid ideas and inept decisions, central banks will find it increasingly difficult (that is, will have to raise policy rates ever higher) to restrain CPI’s rise within the 2-3% bound. That, in turn, will increase the pressure to loosen (i.e., revise upwards) their targets.
Never mind central banks’ boilerplate that they’ll “do whatever it takes” to conquer inflation: the extended period of sluggish GDP growth and ultra-low interest rates after the GFC has spawned a large number of precariously leveraged (“zombie”) businesses, households and above all governments. If central banks’ attempt to maintain their CPI targets by raising their policy rates to painful (to heavily-indebted borrowers) levels, the resultant barrage of ire would threaten their alleged “independence” – and central bankers’ jobs. Arguably, that’s already happening in Australia.
“Only when indebtedness has been restored to viable levels,” Goodhart and Pradhan conclude, “can an assault on inflation be mounted.” That’ll be the day that pigs fly. Clearly, households’ (never mind governments’) indebtedness won’t soon return to viable levels; hence central banks will neither aggressively attack nor conquer consumer price inflation. Vale the “Great Moderation.”