Just three days before the Wall Street crash of 1929, Irving Fisher, the otherwise brilliant economist, stated: “Stock prices have reached what looks like a permanently high plateau.” We saw similar sentiments expressed during the internet boom: remember the 1999 bestseller, Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market?
We are currently seeing sentiments that are similarly entrenched but, unfortunately, in the other direction. It is called the ‘new normal’ – a new era where we fail to generate much economic growth, fail to benefit from innovative technologies, where productivity falls, poor demographic trends kick in, inflation and interest rates stay low, investment returns take a step down… You get the message.
Interpret the evidence
Whether or not this depressed state is permanent is the crucial question. Markets certainly think so. Government bond yields are implying low growth, and inflation markets are implying modest price increases into the distant future. This does not fit all the evidence, however.
Once volatile energy and food prices are stripped out, ‘core’ US inflation is actually on a rising trend, and has been for the past year. Moreover, when examining the categories of goods that comprise this stripped-down inflation basket, the rise in prices is occurring largely across the board.
Housing costs grind higher, medical expense inflation is accelerating, services inflation is climbing and even goods prices, which tend to deflate over time, have bounced. If we were really in a deflationary world, you might expect most categories of expenditure to be falling in price.
The picture changes if we include energy and food prices, to arrive at the more commonly used ‘headline’ measure of inflation. Energy prices are a big component of this measure of inflation and have been plunging, dragging it down.
The chart opposite demonstrates the difference between US core and headline inflation: headline inflation is growing annually by about 1%, whereas core inflation is growing at between 2% and 2.5% annually. Rather than diminish the outlook for inflation, this discrepancy actually cements the likelihood of an increase.
Oil prices cannot continue falling forever; indeed, they have already rebounded from their lows earlier in the year. As a result, the drag from oil is actually going to turn into a mild push. By that time, both measures of inflation will be showing a significant increase.
One of the main causes of price increases is wage growth, which adds to the spending power of consumers and their demand for goods and services. The evidence is also in favour of an upwards inflation trend. Over the past year there has been an uptick in US wage growth to about 2.5% per annum, the highest it has been for six years, though still lacklustre by long-run historical standards.