Generflation: a 30-year view of inflation cycles
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In 1979, as Paul Volcker (above) took over as Chairman of the US Federal Reserve, a generation of investors did not believe central bankers could get the inflation genie back in the bottle. How do we know this? Because at the start of 1980, thirty-year US government bonds were offering an annual yield of more than 12%. Investors demanded that much income every year for thirty years to compensate them for their expected levels of inflation. Even ten years later, though inflation had fallen, investors remained sceptical about the Fed ’ s inflation-fighting bona fides , with thirty-year bonds offering a yield of 8.5%. As we know now, inflation continued to decline over the next thirty years, falling from over 6.5% at the start of 1990 to 1.6% in 2019, and investors in those long bonds did spectacularly well, earning an annual return far above inflation.
Theories abound as to who or what was responsible for this generational decline in inflation. One credible explanation put forward by economists Charles Goodhart and Manoj Pradhan in a recent book, The Great Demographic Reversal, is that the reintegration of eastern Europe and the rise of China provided an enormous increase in the global supply of labour which served to suppress wages and lower the costs of manufacturing. Companies around the world took advantage of this by globalising supply chains, while consumers benefited from the low prices of traded goods.
This era of steady growth, low and stable inflation has been called The Great Moderation and it has recently been rudely interrupted. Trailing inflation in the UK has risen to 9.4% on an annual basis, with the Bank of England forecasting it will exceed 11% by year end. However, the current generation of investors, conditioned by three decades of falling prices, clearly does not believe higher inflation is here to stay — thirty-year gilts are yielding 2.6% and investors will lose money in real terms if annual inflation ends up being any higher than that.
But just as investors were wrong-footed — to their benefit — by the secular shift down in inflation over the last thirty years, might they now be making a mistake in the other direction? It ’ s possible. The former Bank of England Governor, Mervyn King ’ s, term for The Great Moderation was the “NICE” years — Non-Inflationary with Continued Expansion — and Goodhart and Pradhan are firmly of the opinion that the NICE years are about to turn nasty.
The positive supply shock to the supply of global labour from the reintegration of eastern Europe and rise of China has largely run its course. One consequence of China ’ s one-child policy is that all the peasants who left the paddy fields to work in urban factories cannot possibly be replaced: there is one grandchild for every four grandparents. In many developed economies, populations are also ageing and becoming less productive, partly as the old age dependency ratio — the proportion of retirees to workers — increases and partly as an ageing population requires more carers: jobs which cannot readily be exported. At the same time, globalisation appears to be in retreat as we witness a crisis in liberal, free-market economics and a rise in political populism. All of this suggests that many of the deflationary impulses of the last thirty years are about to turn inflationary.
But if investors are to be hurt by a generational increase in inflation, what about the workers? Recent evidence suggests rising prices will hurt workers whose wages struggle to keep up. In the most recent quarter, wages in the UK excluding bonuses lagged inflation by 2.8% and including bonuses still lagged by 0.9%. Clearly, over the last year household budgets have not been able to keep up with the soaring costs of food, fuel and other forms of energy — but is this normal?
Inflation is episodic, which means any discussion about cycles is hampered by the small sample size of observations — in this case a thirty-year period of rising inflation was followed by a thirty-year period of falling inflation. With that caveat in mind, if we look at the thirty-year NICE period from 1990 to 2019, we find real compensation growth in the UK — i.e., after adjusting for inflation — averaged 1.9% a year. In the thirty years from 1960 to 1989, it was 3.2%. In other words, real wage growth was positive throughout but rose more in the inflationary period ending in 1989 than it did during The Great Moderation ending in 2019.
Moreover, labour ’ s share of national income averaged 65% in the first period and 58% in the second. This observation about the last sixty years is backed up by a dataset from the Bank of England that goes back to the thirteenth century, which shows a positive correlation between periods of thirty-year inflation and real wage growth, as you might expect. All this suggests that if we are to see a generational upturn in inflation, it may be accompanied by a rebalancing from capital to labour, with a consequent decline in inequality.
The Government may also fare better in a more inflationary environment, as tax receipts increase in line with the growth in nominal GDP, which includes inflation. In the UK, for instance, tax receipts have recently been setting new records, reducing the budget deficit. What the Government does with these higher tax receipts remains to be seen, but I was struck by the Conservative Party leadership candidate, Kemi Badenoch ’ s, honest admission that when it comes to policy, there aren ’ t solutions per se , only “ trade-offs”.
No doubt the period ahead then will see winners and losers. If inflation takes off, investors in longer-dated, fixed-income securities will suffer in real terms as annual interest payments fail to keep up with inflation. Anyone with income streams tied to inflation, however, will fare better. Investors in inflation-linked bonds will do better than investors in nominal bonds. UK pensioners whose benefits are explicitly inflation-linked will be able to maintain their living standards, while the unemployed, whose benefits are not explicitly linked, will struggle. Workers will benefit from the increased bargaining power brought about by a negative shock in the supply of labour and should see real growth in their compensation. Corporate profit margins, consequently, will decline, which will hurt shareholders. The Government, meanwhile, will see revenues rise quicker than expenditures, lowering the deficit.
In 2021 the old age dependency ratio — the number of people of pensionable age as a proportion of the adult working population — was 28% and had been around that level since the early nineties. Thirty years from now, the Office of National Statistics forecasts this ratio will have risen to 36%. With fewer workers supporting an ever-increasing number of retirees, taxes on workers will have to rise and/or benefits to pensioners reduced. Barring an unlikely surge in labour productivity and/or birth rates, there is no solution to this demographic timebomb — it ’ s the future that has already happened — there are only trade-offs. Clearly, at some point in the next thirty years, some tough decisions will need to be made.
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