Why isn’t inflation coming back?

Year-over-year CPI change. Source: Bloomberg

In the ‘60s and ‘70s inflation grew out of control. Nixon’s price controls didn’t stop it. But it settled down after Paul Volker’s restrictive monetary policy and Alan Greenspan’s careful management of the Fed. Economist Milton Friedman famously claimed that inflation is “always and everywhere a monetary phenomenon.” But after the financial crisis, inflation dipped below zero and the Fed flooded the economy with money. Many feared that inflation would come roaring back.

But this didn’t happen. Prices have been pretty stable. In fact, inflation still seems to be on a downward trend that began around 1990. Why?

A lot of theories have been proposed—the Fed’s money just “sat in the banks,” the rate that money circulated through the economy fell, that assets have inflated via bubbles while consumer goods have stagnated. But these seem to miss the point, or to be tautologies. The economy’s money supply has expanded dramatically, but consumer prices have grown at a snail’s pace.

M2 growth and Core CPI growth, year-over-year. Source: FRED

It’s not enough to say that monetary policy acts with long and variable lags. M2 is the most common measure of transactional money—what we use to purchase goods and services. It’s been growing faster than 5% for over six years. Both core and headline inflation, however, remains extremely low.

The problem must lie in the theory—the theory that dictates that inflation is exclusively a monetary issue. There must be elements of the real economy keeping inflation in check. I see three large-scale, long-term issues. First, the US economy is far more integrated with the rest of the world than ever before. And we do not have good data on global money supply. Second, global demographics limit demand. Populations around the world are aging—in some cases, quite dramatically. This is because life-expectancy is rising while fertility rates are falling. This is happening in almost every country around the world, but especially in high-demand countries like Europe and Japan. Since 1980, the share of the world’s population over 60 has grown from 8.5% to 12.3%, and older folks don’t consume as much as younger people.

Source: UN

Finally, technological innovation continues to challenge traditional economic equations. The cost of distributing a movie to a billion wired households is only marginally greater than streaming it to a million homes. Information is not conserved, the way that material and energy are. Digital information can be copied and multiplied for almost nothing. This radical change in the economy continues to disrupt business models, from record stores to hotels and restaurants to airlines. There’s a lot less need to travel when videoconferencing is almost like being there in person.

This has profound investment implications—from Fed policy and bond yields to business models, profit margins, and stock prices. Although difficult for monetarists to confront, the data from the last 20 years seem conclusive: inflation is—at least partially—real.

Douglas R. Tengdin, CFA

Chief Investment Officer