A new era for inflation

Key takeaways

• We may now be seeing the end of a long period of disinflation and low inflation that stretches back to the early 1980s and instead entering an age of more sustained structural inflation.
• We have identified five big secular drivers in our projections for long-term inflation: demographics, innovation, globalisation, energy transition and big government.
• The regime shift toward higher long-term inflation will have deep and long-lasting implications for asset-class dynamics and strategic asset allocation.
  

Global inflation: 40 years of disinflation has probably ended

The growth recovery from the shock of the pandemic has been accompanied by a sharp rise in global inflation, exacerbated by supply-chain logjams against a backdrop of abundant fiscal and monetary support. But we think the abrupt surge in prices is hiding some deeper structural forces that mean inflation could be much higher on average in the coming years than it was before covid. 

In other words, we believe that a period of almost 40 years of disinflation – a regime in which inflation remained very low in developed economies – is ending. The epicentre of this new regime could be the US, where we expect structural inflation of close to 3% in the coming years, way above its 1.8% average level in the decade before the pandemic.

We believe there are five main drivers of structural inflation: globalisation, the energy transition, state intervention, demographics and innovation. We consider each briefly below.

For illustration purposes only. There can be no assurance that these projections, forecasts or expected returns will be achieved. The projection is not based on simulated past performance.

Five main drivers of structural inflation

Innovation

Innovation has also historically been viewed as disinflationary, but the rise of big-tech platforms may be holding back competition by creating large barriers to entry and de-facto monopolies. If this is the case, the natural propensity of innovation to act as a driver of deflation may decline in the coming years.

Demographics

The ageing of the global population has long been seen as disinflationary in nature, with Japan held up as the prime example. However, some economists have highlighted the potential for ageing to reduce the size of the pool of workers, pushing up wages. Changing demographics may not be as deflationary as was once believed.

Globalisation

The process of globalisation, which can be broadly defined as the integration of the global economy through trade, capital and migration flows, may proceed more slowly in the years ahead. Some of the factors behind this deceleration pre-date the pandemic, such as US-driven trade tariffs, especially those focused on imports from China instigated in 2018.

Meanwhile, the pandemic – with border closures and interruptions on the main sea routes as well as in some ports – highlighted the fragility of global supply chains. Meanwhile, the demographic transition in China and the sharp rise in its domestic manufacturing costs could mean China’s role in global supply chains changes. All these forces could increase the trend towards ‘re-shoring’ – in other words, the repatriation of some manufacturing production closer to end-markets, even it this means a higher cost of production. We believe these higher costs of production are likely to end up being passed on to consumers.

State intervention

State involvement in the economy increased dramatically during the pandemic (The Economist referred to ‘a new era of big government’ in November 2021), and it could be set to increase further in the coming years. This is likely to put more upwards pressure on structural inflation through additional artificial boosting of demand, such as through the use of income-support schemes, and also through additional regulation of business activity and the labour market. Governments may also apply greater pressure on central banks to keep interest rates below the rate of inflation so that their borrowing costs remain affordable in a context of increased spending.

Energy transition

We identified the energy transition as a contributor to higher long-term inflation in a previous edition of Horizon. We still expect the direct and indirect costs of transitioning to carbon-free energy to result in higher energy costs, and therefore higher prices for consumers. Meanwhile, there is likely to be a trend towards the ‘internalisation’ of production, by which we mean the incorporation of the cost of pollution into prices paid by end users.

Inflation forecasts

Taking factors such as these into account, we forecast that inflation will reach a long-term average of 3.2% in China, 2.7% in the UK, 2.8% in the US and 1.9% in the euro area. We believe it will remain lower in Japan at 0.9%, but that rate would still be above its pre-pandemic average of 0.5%. Several of our economic models suggest that inflation could rise higher than these levels towards the end of our 10-year forecasting window, particularly in the US.

Such a regime shift towards higher structural inflation could have deep and long-lasting implications for asset-class dynamics and strategic asset allocation decisions. Investors relying on sources of fixed income could be hit especially hard as interest rates could rise, and incorporate more of an inflation risk premium. Higher long-term inflation could have consequences for monetary policy, and it would undoubtedly exacerbate the usual growth-inflation dilemmas faced by policymakers. Finally, increased inflation could also put financial stability at risk as it tends to increase the volatility both of macroeconomic data and the policy response to it.