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Inflation’s Four Factors
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Andrew Kositkun Senior FX Advisor
When attempting to forecast inflation, a popular approach is to run developments through a series of structural components in order to judge whether disinflationary forces outweigh inflationary forces. Here’s a quick look at four key structural factors that inform inflation expectations:
Demographics: Older people tend to spend less and are more conservative. Therefore, inflation tends to fall as the population ages. The complication with this factor is that while retirees do tend to spend less, they — by definition — produce less. Retirements weaken the supply of goods and services more than they weaken demand, so all else being equal, an aging population is inflationary.
Debt levels: High indebtedness is disinflationary because high debt causes people to cut back on spending to pay down the debt. However, during the debt buildup phase, rising debt does spur aggregate demand as people spend beyond their incomes. Currently, the U.S. and much of the world are rapidly adding to debt totals and stimulating spending. Eventually, when governments get serious about managing debt levels, aggregate demand should weaken, but for now, a shift toward fiscal discipline is still a long way off.
Unequal income and wealth: Upper-income people have a smaller propensity to consume; thus, growing wealth inequality should weaken demand. However, income and wealth inequality have been rising since the 1970s, a period during which there has been a wide range of inflation outcomes. Additionally, some of the highest inflation in the world is in emerging market economies with extreme levels of inequality.
Cost-savings technologies: Rapid productivity increases tend to reduce costs and inflation by slowing the growth in costs. This was the case in the late 1990s when productivity increases allowed the U.S. economy to run hotter without inflation. But once the economy adjusts to the new growth in productivity, inflation can resurface.
Beyond these four key factors, it is important to remember that there are other trends that impact inflation expectations. For example, decoupling global supply chains has both inflationary and disinflationary implications. Increased uncertainty can reduce aggregate demand. We saw this play out during the recent trade war when business investments dropped. Conversely, rejiggering global supply chains hurts global productivity, as it requires duplication and less efficient allocation of resources, leading to higher costs and negative supply shocks.
Similar factors are at play with green investments. In the short run, green investments lower productivity growth as businesses shift to less cost-efficient processes. Simply put, if being green maximized productivity, companies would have made the changes voluntarily. Over the long run, green investments should make the economy more sustainable to major downside shocks that hit productivity.
Bottom line: The point is not that all of these forces lack predictive powers but that they all need to be put in the context of aggregate supply and demand. On this dimension, fiscal and monetary policy often plays a dominant role. U.S. policymakers appear determined to break from the past couple of decades and engineer very rapid aggregate demand growth and tight capacity by the end of next year. Conversely, Europe and Japan are pursuing less aggressive policies, meaning they are more likely to remain mired in chronic low rates and inflation.
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