Inflation: Always and Everywhere a Political Choice

00:04 - 00:22

Hi, everyone, and welcome to The Pulse, where we discuss trends in the economy, markets and asset allocation for long-term investors. I'm Matt Palazzolo, senior investment strategist at Bernstein and Head of Investment Insights. A couple of months ago, I spoke with Bernstein economist Eric Winograd about the post-pandemic recovery, and we touched on inflation.

00:22 - 00:40

Inflation is a persistent increase in prices that goes on for a long period of time and that people expect to see continue. So it's premature to call what we have seen so far inflation, what we have seen is an increase in prices. If that were to continue for a long time, then we would have inflation.

00:40 - 01:08

He pointed out that while elevated prices of late may be alarming to some investors, it's good to remember that for the last 10 years, the US has actually fallen short of many inflation targets. And a lot of the reason why we're seeing now higher inflation is attributable to temporary economic bottlenecks due to the pandemic. But it's also important to remember that we are in anomalous times. This is a unique period in modern economic history.

01:08 - 01:15

There hasn't been a crisis that was caused by something quite like this pandemic. And so to an extent, we are in uncharted waters.

01:15 - 01:20

But these unchartered waters will influence what normal looks like a decade from now.

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And so to discuss this point a little bit further, I'm pleased to be joined by Darren Williams, AllianceBernstein director of global economic research and Darren team recently published an in-depth look at the factors which they believe could cause the world's major economies to enter a new higher inflation regime over the coming decade. Darren is joining us all the way from London. Darren.

01:42 - 01:44

Welcome to the show! Yeah. Hi, Matt. Thanks for having me.

01:44 - 02:10

Darren I have to say, I read your white paper over the weekend and I mean, I thought it was fantastic. It covers in-depth and thoroughly the case for higher inflation over the foreseeable future, but it's also accessible to non-economists, which is what I really appreciated. Before we delve into some of these details in your paper, can you just give us a quick overview on you and your team's conclusions?

02:11 - 02:48

Yeah, very happily. I'm glad you found the piece accessible. We take a lot of pride in trying to make sort of economics relevant to the real world. And I think in this piece, we've taken a slightly different approach to inflation than many other economists do. What we're arguing in the paper, essentially, is that inflation is ultimately a function of the policy regime, and for the last 30 or 40 years, the policy regime has been all about maintaining very low inflation. The big question is whether that's the case again today, and we think the answer to that is not because there are other aims that governments and society have, which are creeping up the policy agenda.

02:48 - 03:21

So, for example, inequality is one of those. Probably the most important often is the battle against the sort of climate crisis, which is an existential threat to some extent. So as those factors begin to climb up the policy agenda, inflation begins to fall down the policy agenda. And history tells us that when inflation tends to fall down the policy agenda, it tends to start to increase. So it's all about inflation being a reflection of society's aims, rather than something which we would regard as being a function of the business cycle.

03:21 - 03:49

Yeah, I think that's certainly the aha moment for many of our readers. Once they get to it, that this is very much a political choice as opposed to something that occurs from just natural occurrences in the economy or the cycle. Your paper has an interesting starting point, which is to point out the shortcomings in traditional models and explain what kinds of drivers we need to pay attention to over the secular horizon. You touch on the Phillips curve, maybe flesh that out a little bit for us.

03:49 - 04:22

Yeah, it's not that there's anything wrong with the Phillips curve, it's just that people often apply it to the wrong time horizon. So the Phillips curve is a really useful tool for thinking about the behavior of inflation during the business cycle. So at the beginning of the business cycle, where you have a lot of spare capacity, unemployment is high. Then inflation tends to be low; as you move through the cycle and unemployment falls, you have less spare capacity; inflation tends to rise. That's a really sensible way of thinking about the cyclical behavior of inflation, but it doesn't tell you anything much at all about the secular or longer term outlook for inflation.

04:22 - 04:50

And when we begin to look over longer horizons, we start to take into account other sort of secular drivers. And the most obvious of those at the moment are things like demographics, populism, technology, things like that, which can have an impact on inflation over longer horizons. But the ultimate driving factor, and I think this is the key point of the paper, is that what ultimately determines inflation is the policy regime, and I want to use two numbers to demonstrate that.

04:50 - 05:47

So I'm going to refer to my own country, the UK. So the Napoleonic Wars ended in 1815, and between 1815 at the beginning of World War I, you had, what, 99 years, to 1914? UK was on the gold standard during that time frame and the average rate of inflation over that whole time frame was exactly zero, nought point nought percent per annum. Now, from the end of World War I, 1919, until today is roughly 100 years, so roughly the same type of time frame. And for almost all of that period, the UK has been off the gold standard and on a paper money standard, and the average rate of inflation over that time frame has been 4.0 percent. So you've had a lot of different things going on in those periods. You've had lots of different business cycles, you've had lots of technological change, but very, very different rates of inflation and the obvious thing which is staring at us in our faces from all of that is that it's the policy regime which is determining the inflation outcome of very long horizons.

05:47 - 06:10

And that was one of your key conclusions that you started with when I asked that question right at the top of the show. And you actually do say in your white paper, inflation is always and everywhere a political choice. You know, maybe explain to our audience what you mean by that. Maybe take it a little bit further and how politics now, and you touched on some of those priorities, but politics now may lead to higher inflation over the next 10 years or so.

06:10 - 07:06

Yes, I think we need first to give due credit to Milton Friedman, a very famous economist and Nobel laureate who coined that phrase in slightly different terms. So Mr. Friedman said that inflation was always and everywhere a monetary phenomenon. And that's right. Or at least it's half right. I think what we have to ask is how do those monetary phenomena arise? And from our perspective, again, it's all about the policy regime and political choices. If we look at the postwar environment generally, so after World War II, the real aim for most governments was to deliver full employment. So that was the overriding policy aim. As a result of that, as you run into the 1970s, we ended up with rampant inflation. The policy response to that at the end of the 1970s and into the early 1980s was to make inflation the number one sort of policy aim. Low inflation was the overriding aim of economic policy, and of course, we managed to deliver that. It took a little while, but we managed to deliver that. Now as we look around today,

07:06 - 07:40

I don't think you're going to find a lot of people telling you that the thing that they're most worried about is inflation. But I got to tell you that they're worried about climate change. They're going to tell you that they're worried about inequality. And so it's highly likely that the political system will revert. And we use a sort of throwaway line in the paper, which we say, you know, ultimately, who would think that four or five percent inflation is a worthy price to pay for saving the planet? Now, it's a little bit of a throwaway line, but I hope you get the general idea there that if that's what it needs for us to be able to afford the green transition, if that's what it needs for us to be able to tackle inequality, then hey, is four percent inflation really so bad?

07:40 - 07:53

And at the moment, most major economies are dealing with record levels of debt. How does that fact play into your forecast for higher levels of inflation in the out years?

07:53 - 08:39

It seems to us that the easiest way or the most possible way of managing and controlling debt is to use a combination of two things. One is to use what economists like to call financial repression, which is a kind of fancy term for basically putting yield caps on or keeping bond yields and government financing costs lower than they otherwise would be. And if you combine that with higher inflation so that you get negative real interest rates, then over time that effectively erodes the real value of the debt. So I don't think any government or any central bank would subscribe to the idea that they would be deliberately trying to inflate away the government debt. But again, it's something that's quite convenient. If we end up in that world of three or four or five percent inflation, then government debt and private sector debt actually becomes less of a problem.

08:40 - 09:12

And there's a very famous quote that I kind of like to use from John Maynard Keynes, which he made in the early 1920s when he talked about this sort of persistence of inflation over economic history. And Keynes said that it wasn't any accident. It was basically down to two things. It was due to something he called the curiosity of governments. What he basically said was that governments borrowed too much money, and then he said it was also due to the superior political influence of the debtor class. And again, it's not superior political influence of the debtor class, which would tend to favor higher inflation in a world where we have lots of government and private sector debt.

09:13 - 09:47

So I keep coming back to what seems to be a theme in your work that this is a political choice, political choice to tackle certain initiatives, be it climate change or income inequality, and maybe not as explicitly another political choice to, I want to say, inflate your way out of the debt issue, but that's essentially what it is to keep interest rates low so that the carrying cost of those record levels of debt remain low and manageable, arguably. And then to reduce the real level of that debt by having somewhat higher levels of inflation than we've seen over the last couple of years.

09:47 - 10:14

I know and I've discussed this topic and your conclusions with several of our clients in an area that I know that we and you get some pushback as it relates to potentially higher inflation is technology and technology's ability to offset these other drivers; and yet in your paper, you go right at that pushback and you present some evidence on why that might not be as disinflationary. Can you discuss that for our listeners?

10:14 - 10:58

Yes. So we realize we're swimming against the tide. I don't think there's any arguments about the fact that as a standalone factor, technology is likely to weigh down on inflation. The question we have is whether it by itself is powerful enough to offset the big secular change in the policy regime. And the history certainly from the UK would suggest that it's not. So we show in the paper, for example, the behavior of cotton prices and coal prices during the industrial revolution in the UK, and it wasn't always down with the general price level actually went up during that period, despite the fact that coal prices and carbon prices were collapsing as productivity improved, and at the risk of maybe quoting too many long-term historical figures, I want to throw a couple out to you.

10:58 - 11:50

So Industrial Revolution, the first industrial revolution in the UK started in 1760, and since then the average rate of inflation has been 2.2 percent. We've been almost in a continuous cycle of industrial revolutions, technological revolutions ever since then, but the average rate of inflation has been 2.2 percent. More pertinently, in the period since 1760, in which the UK has been using a hard currency regime, the inflation rate was negative 0.1 percent per annum; during the fiat currency periods; paper manic periods realistically ever since the 1930s, the average rate of inflation has been five percent. Again, this in quite basic figures and maybe seem a little bit simplistic, but sometimes the world is actually quite simple. And that seems to me to be quite compelling evidence that the policy regime and your attitude towards money really matters when it comes to determining inflation outcomes over the long horizon.

11:50 - 12:04

And just related to a couple of your answers, you're quoting data from the UK and your paper does it as well. Is there a reason why is it that the UK captured that data for a longer period of time? Or is it more accurate than other major economies? What's the reason?

12:04 - 12:45

I'm not sure it's necessarily more accurate. It's just the fact that the UK has a kind of wealth of historical data, and the Bank of England has its sort of fascinating… If anybody really has some spare time, the Bank of England on its website has in millennia of economic data. Now, it doesn't have every piece of economic data going back a thousand years, but it has a pretty comprehensive view of population trends, inflation, economic growth, et cetera. And we've used that quite extensively in our work together with some other sources to get the data. We did in the paper, because I'm conscious that the UK is sort of only a relatively small part of the world nowadays, so we are conscious that it's nice to draw some historical experience from elsewhere.

12:45 - 13:17

And actually, we came across a really fascinating body of research on the US Civil War, and that was nice because it allowed us to take a US perspective. It was worrying because I am not a US citizen and my US economic history is not as strong as my UK economic history. But what was really fascinating is that during the Civil War, the Confederate currency, the Greyback, depreciated by 9000 percent. I mean, it was a ferocious hyperinflation. So you had a constant devaluation of the value of the currency during that period and constant inflation, except for one brief period, which was pretty fascinating.

13:17 - 14:07

So in 1864, the Confederacy had a currency reform to prevent inflation and to stabilize the currency. The only problem was that at that time, the Union forces controlled the Mississippi, so the Confederacy was effectively split in two. And so the currency reform only actually took place in the eastern states and didn't take place in the western states. So you had exactly the same economic backdrop. You had exactly the same war conditions. But what actually happened was that the currency reform stabilized the currency on the price level in the eastern states, whereas in the western states, the currency continued to devalue and inflation continued to accelerate. So you had almost that sort of real-world testing of example, obviously against a pretty horrific backdrop of a civil war, of demonstrating that the policy regime, your attitude towards the currency really matters when it comes to determining inflation.

14:07 - 14:17

I thought that was fascinating when I read that. You would try to build a model that would replicate essentially what happened during the Civil War, to have that separation and then to look at the impacts of essentially a control state and a non-controlled state.

14:17 - 14:30

Yes, I mean, obviously a horrific backdrop within which to conduct such an experiment, but a unique, as you say, test tube example, in a sense, demonstrating the power of the quantity theory of money or the power of the policy regime.

14:30 - 14:58

Let's start to pull it together. But before we do, I've said a number of times I've asked you and pointed you towards the next decade or so. I don't want to put words in your mouth, and I know it's difficult. But for this forecast of yours and your teams for modestly higher inflation over the foreseeable future in the major economies, what time period should our investors be thinking about? As you rightly say, Mat, that we've gone backwards and forwards on this one a lot and my conviction level on the direction of the forecast is really high.

14:58 - 15:21

My conviction level on the timing is obviously somewhat lower, and part of that I think reflects the political nature of the decision. So I'll give you a short answer and I'll give you a somewhat longer answer. The short answer is to think about this as being something that we expect to develop over maybe a three-to-five-year time horizon, perhaps a little bit longer. It's something that we think is kind of unlikely to develop over the very short term.

15:21 - 15:57

The longer answer is we've tried to think about this a little bit from a kind of, maybe to borrow a Hercule Poirot or inspector Colombo's or Detective Colombo's sort of case because sort of means, motive, and opportunity approach to this. What we mean by that is over the last sort of 12 to 18 months, governments and central banks around the world have had the opportunity to experiment with effectively central bank financed fiscal expansion so that they've experimented with the means to create higher inflation. The motive is pretty clear, so the motive is really all about climate change, inequality.

15:57 - 16:22

So the idea that there are more pressing imperatives for governments and society to address than low inflation, so we have the means, we have the motives. What we really need now is the opportunity, and I think that's where the political angle comes in. Were we convinced that governments around the world are in the very short-term going to sort of open the fiscal floodgates to spend more money on the climate transition, et cetera, then I think I would be more convinced that the inflation impact would come through sooner.

16:22 - 16:51

Of course, that's quite difficult to be confident on because if I were to speak to Eric Winograd, my colleague in the US, he would tell me, for example, that the outcome of the next midterm elections in the US is going to be very crucial towards determining fiscal response in the US. So there's a very clear political angle by which we’ll determine the timing. But again, I'll go back to the short answer. I think we should be looking for a transition towards that over the next three to five years. And I think fiscal policy is going to be the absolute key variable to watch when it comes to determining that timing.

16:52 - 17:06

OK, let's keep trying to pin you down. Can you quantify your forecast for inflation for these G7, the largest seven countries across the world? What levels of inflation are we looking at? I don't want listeners walking away thinking that we're going back to the 1970s unless you believe that we are.

17:06 - 17:55

No, I very much doubt we would be going back to the 1970; if we threatened to go back to the 1970s. I lived during the 1970s and it was not a fun... It was not a fun time in the UK from an economic perspective. If there's any threat of us going in that direction, then I think central banks would act really, really aggressively to stamp that out. So the type of inflation we're talking about is more in this three and a half, 4.5 percent range. So it's not corrosive. It's likely to be stable at those sort of levels so people can plan for that type of inflation. And that's why we say, that sort of inflation is probably seen as a fairly acceptable price to pay, one for society to reach some of its aims, again, the climate transition, et cetera. And to, as we noted a little bit earlier, the idea that that makes the whole debt problem that the world still faces much more manageable under those sort of circumstances.

17:56 - 18:24

There you have it, three to five percent or so inflation starting to appear in the next three to five years. And from Darren’s team, a fairly high, within economic terms, a fairly high level of confidence with good conclusions and evidence as to why that would occur over that timeframe and at that level. So, Darren, I want to thank you very much for joining us today from a steamy London. We appreciate your time and certainly your perspective on inflation both now and we'd love to have you back as the evidence starts to unfold.

18:24 - 18:26

Thank you very much. I'd love to do so.

18:26 - 19:03

And for all of our listeners today, thanks for joining us as well. We hope that today's conversation helps to illuminate the topic of inflation and certainly our perspective on it. And for more on inflation, we have two deep research pieces, which we think are well worth your time. They're linked in this episode's description, and the first is the one we've been talking about today, Darren’s white paper. And the second is our Investment Strategy Group at Bernstein's work on inflation, which covers why inflation is such a challenge for investors, how to gauge your own sensitivity to it, and how you can protect your portfolio from it. And we'll have more on that in an upcoming episode as well.

19:03 - 19:27

As always, we'll continue to monitor these key trends and risks in the economy and share them with you here on The Pulse. And so if you've enjoyed this podcast, please subscribe and rate us on Apple Podcasts or Google Play or Spotify or wherever you listen to podcasts. And of course, e-mail us with your thoughts or questions or feedback to insights@Bernstein.com. Be sure to find us on Instagram and Twitter at BernsteinPWM. Thanks again. And be well.