Is inflation coming back?

Public Domain. Source: Pikrepo.

The balloons are out! The end is in sight. Despite Covid-fatigue, new lockdown restrictions, surging infections, and political controversies, we can see some light at the end of the tunnel. The largest global investment in public health in history is bearing fruit: vaccines designed to fight the COVID-19 virus have proven to be safe and effective, and companies are applying for final certification and are ramping up production. Some countries have already begun their vaccination programs.

So what will happen to the economy? Once things open up, will we see a wave of consumption? And are all those celebratory balloons a bad omen? Are we inflating the balloons, just in time to inflate the economy? Will all the money that’s been injected lead to an inflationary spiral of higher prices, higher wages, and higher spending? Disposable income is up, household balance sheets are strong, and consumers have over $2.4 trillion in their savings accounts.

An unexpected, sustained increase in inflation would be the worst thing possible for the markets. 10-year government bonds yield less than 1%. Most bonds in Europe have negative yields. And the Fed has said they’re committed to keeping rates low until inflation makes a comeback. What if they miscalculate and inflation gets out of control?

When I was first studying economics, the inflation of the ‘60s and ’70s was a recent thing. There was a broad consensus that it had been caused by the Fed’s too-little-too-late policies, and by their monetizing the Federal deficit. Too many dollars chasing too few goods had spiraled out of control, and stagflation was the result.

But that story was too simple. The ‘70s were also a time of great resource constraints. The formation of OPEC, the nationalization of international oil companies, strikes by miners and truckers and auto workers all contributed to a wage-price spiral. President Nixon tried phase after phase of national price controls, to no avail. In fact, by trying to control prices from the top down, those controls probably made things worse. Inflation topped out at over 13% by 1979.

Source: Bloomberg

But as Gerald Ford’s economic advisor noted, if something can’t continue it will stop. Aggressive policy tightening by the Fed, supply-side reforms to the tax code that encouraged production, and – especially – technological innovations that improved productivity led to a dramatic turnaround in inflation. The latest statistics show that the inflation rate is 1.2% — less than one tenth the rate it was 30 years ago.

Source: Bloomberg

Inflation remains on a downward trend, driven by technological improvements and aging demographics. Around the world, populations are getting older, and older people simply don’t spend as much. Economist Ed Yardeni developed an “age-wave” model of inflation, showing a strong correlation between the percentage of the workforce aged 16-34 and the inflation rate. Guess what? Workers and inflation are headed lower.

Source: Yardeni Economics

Finally, the structure of our economy has changed. We simply don’t consumer as much stuff any more. We have a “dematerializing” economy, where we spend money on all kinds of services: streaming services like Netflix, shopping services like Doordash, meal services like BlueApron and HelloFresh. Mobile technology combined with cloud computing and high-speed broadband is only beginning to affect the economy.

So no, I don’t expect a long-term increase in inflation. The short-term impact of the pandemic was deflationary, as consumption fell off a cliff. So there might be a quick snap-back in some prices as the economy opens back up. But the trends that were in place before the pandemic are still in place: software is eating the world, people are getting older, and there’s been an incredible amount of investment in productive assets.

So will inflation come back? I think that balloon has been popped. And once a balloon is popped, it’s impossible to blow it back up.