Why Is Inflation Stubbornly Low?

7/11/2017 – Global inflation has been stubbornly low for quite some time, creating a difficult situation for central bankers. Of course, central bank action is highly dependent upon inflation levels. And their actions have direct and immediate influence on global stock and bond prices. The problem? U.S. inflation measured by the core PCE has undershot the Fed’s target rate of 2.0% for the previous 59 months.

As a recap, core PCE (personal consumption expenditure) excludes energy and food prices as they are extremely volatile (a breakdown of PCE is here). According to traditional economics, as the economy continues its recovery and as the unemployment level falls, the price for goods and services should rise. The logic behind this idea is that the U.S. economy is driven by its consumers (71% of U.S. GDP is consumption). So, as the economy recovers, it is safe to assume that consumption increases. Therefore, businesses selling goods and services to consumers should be able to increase price, which increases their profits.

However, we have not been seeing this, even with the unemployment rate falling to pre-2008 levels and as the economy has continued to hire workers.

U.S. Unemployment Rate. Source: Bureau of Labor Statistics

A few factors that might help explain why inflation remains stubbornly low include money not in circulation, the fall in the price of oil, and price discovery.

QE: $ not in circulation

When the topic of inflation comes up during a meeting with my clients, many mention the Federal Reserve’s “printing press.” The argument goes something like this, “If the Fed has printed all of money via quantitative easing, wouldn’t that lead to a devaluation of the U.S. Dollar, and subsequent higher levels of inflation?” Well, the simple answer should be yes, but there is a critical piece missing in all of this. The trillions of dollars (yes, trillions) that the Fed “printed” from 2008 to 2014 has not entered the economy.

Federa Reserve Balance Sheet. Source: federalreserve.gov

Quantitative Easing is not akin to printing money. QE is the process by which a central bank will purchase financial securities (usually government bonds) with a money supply that is created from the Fed. In this case, the Fed purchased the majority of those securities (bonds) directly from the U.S. Treasury. Those securities has been sitting on the Fed’s balance sheet. However, the Fed has recently hinted that they might begin to unwind these positions.

The vast majority of the cash that the Fed used to pay for these securities has found its way back to the Federal Reserve as “excess reserves” (red more on this topic here). This means that of all the dollars “printed,” the vast majority of it is not in circulation. Rather, it is on deposit at the Federal Reserve. The actual amount of currency in circulation has been increasing, but at a very gradual rate.

Currency in circulation vs. institution deposits. Source: federalreserve.org

Oil Has Collapsed

One critical reason why inflation has underperformed can be attributed to the dramatic fall in oil.

Oil is a major input in the global economy. It fuels transportation, warms homes, and is used in the making most products. If the price of oil were to rise, so would the end price to the consumer. As such, the price of oil fell over the past several years. Companies did not pass this cost savings back to the consumer. Rather, it kept those savings while keeping prices relatively stable, hampering inflationary efforts.

Amazon’s Price Discovery: Impact of Technology on Inflation

Price discovery is the process of which a marketplace (buyers and sellers) determines the price of an asset. The more information that is readily available, the more accurate the price will be to its intrinsic value. While price discovery is typically used a term when talking about stocks, futures, options, etc., it can also be used in day-to-day transactions (e.g. grocery shopping, car buying, etc.).

As technological advances continue, more and more people are connected to the online world. And with this connection, we have access to an endless amount of information. While access to the internet (whether it be from your home or work computer or your cell phone) has definitely had an impact, I think the bigger impact is Amazon.

Amazon has an incredible 43% marketshare of all online retail sales and 53% of all online sales growth in the U.S. (Slice)

It’s giant scale and automation has allowed it to compete, and win, against some of the world’s largest retailers. Simply put, these traditional retailers are having a very difficult time competing against a business that is willing to operate at a 1% margin. This has allowed Amazon to grow at an blistering pace, stealing marketshare from long-standing traditional retailers. And Amazon’s presence has allowed anyone with a cell phone or a computer to have fast and easy price discovery, often times between multiple sellers on Amazon’s platform. Amazon has brilliantly positioned itself as a market provider, not as a product provider.

Because consumers now have the ability to shop for different products and the ability to compare them against each other, this makes for a more competitive marketplace. And as the level of competition increases, the applied pressure on price increases.

Bottom Line

While these three examples may explain part of the reason why inflation levels have been so low, it likely does not explain the entire reason. Some would argue that a stagnant economy can be to blame. However, the global economy has been growing at a faster rate during the previous year, yet inflation still remains low. The question is now whether central bank intervention will finally overcome these previous inflationary headwinds in the near future. Remember, the central bank balance sheets can’t stay this inflated forever.

 

Ryan Hughes
Bull Oak Capital
Bull Oak Newsletter
7/11/2017


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