Inflation – The usual suspects

Inflation can be a very challenging subject. In our discussions with investors about the economy, we find more diverse opinions on the outlook for inflation than around any other topic. Unfortunately, research on the subject often raises more questions than it answers. For example, academics find that inflation is difficult to forecast, that the statistical properties of inflation can change over time, that inflation expectations differ by demographic groups, and that firms take into account morale and other behavioral factors when setting wages. Of course, quantitative easing also exposed some wide differences of opinion on the drivers of inflation among mainstream economists.

Even so, we are not entirely in the dark about how and why inflation moves around. There are basically four things that matter empirically: (1) commodity prices, (2) spare capacity, (3) changes in exchange rates, and (4) monetary policy, broadly defined. These four variables go a long way to explaining both the level of inflation we see today, as well as the major differences across countries, and can serve as a guide to where inflation might be heading in the future.

The simplest input is obviously commodity prices. Changes in commodity prices due to supply shocks affect inflation everywhere, although to varying degrees due to firms’ price setting behavior, government regulations or subsidies, and differences in the household consumption basket. Commodity prices have been pretty tame lately, which is one important factor behind modest inflation over the last two years (Exhibit 1).

Exhibit 1: Tame commodity prices help explain lower inflation

We can also see reasonably clear evidence that spare capacity in many countries has weighed on inflation. For example, the average level of inflation in developed market economies has fallen from around 2% in 2010 to 0.8% as of the first quarter of this year (unweighted average of gross domestic product (GDP) deflator inflation for the countries shown in the next chart). We think this slowing very likely reflects the second eurozone recession and the resulting increase in slack in labor and product markets.

This point comes across most clearly when looking at the differences in inflation across countries. Exhibit 2 shows inflation in the GDP price index for 25 developed market economies plus the eurozone as of Q1 2014 (the latest available observation in most cases). While there are a few caveats and special factors, inflation is generally higher in countries with smaller output gaps (e.g., Norway, New Zealand and Germany) and lower in countries with bigger output gaps (e.g., Cyprus, Greece, Ireland and Spain). These data are entirely consistent with the historical evidence that weakness in the real economy puts downward pressure on inflation.

Exhibit 2: Lower inflation in economies with weaker real activity

In emerging market (EM) economies — where growth has held up better in recent years — we have not seen this same broad-based slowing in inflation. Instead, recent differences in inflation across EM have more to do with exchange rates and monetary policy (Exhibit 3). For example, inflation has picked up in Turkey, where the exchange rate depreciated sharply last year. Other differences are explained by monetary policy in some shape or form, such as the central bank’s choice of inflation target, the exchange rate regime and/or quasi-fiscal operations by the central bank (as in Venezuela).

Exhibit 3: Exchange rates and monetary policy are major factors in EM inflation

In our view, therefore, current inflation rates are well explained by the usual suspects: commodity prices, spare capacity, changes in exchange rates and monetary policy. These same factors will likely drive inflation in the year ahead, with important implications for bond markets. Aside from uncertainty around commodity prices, we should expect higher inflation in economies approaching or already beyond full employment, especially where inflation rates are currently below the central bank’s target (as in the United States). In these markets rising inflation could be a headwind for high-quality fixed income returns. In contrast, in markets with prospects for a trend lower in inflation expectations (e.g. certain pockets of EM), falling yield levels could still boost excess returns over time.