A new theory on why inflation could return and why I think it may be wrong

A new book by two acclaimed economists argues that inflation could return. Don't immediately go out and buy gold yet; I think the theory could be wrong.

Article updated: 23 November 2020 1:00pm Author: Michael Baxter

Charles Goodhart, a former member of the Bank of England's interest rate-setting committee, has a law named after him. Goodhart's Law "Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes." Mr Goodhart, along with an ex Morgan Stanley Managing Director Manoj Pradhan have penned a book entitled The Great Demographic Reversal.

The book argues that inflation and interest rates are going to rise with a reversal of the trend seen over the last two decades or so.

More than one theory

Let me digress for five paragraphs. One day, inflation will return. If you keep predicting its return, then eventually you will be right. For as long as I have been writing about this topic, someone somewhere has been predicting a return of inflation.

After 2008 we were told that QE would let the inflation genie out. Back then, Jens Weidmann, President of the German central bank —the Bundesbank — likened quantitative easing to a Faustian pact with the devil. But we can now say those warnings were wrong. Sure we had inflation of asset prices, but not the form of inflation that preoccupies policymakers. The reason why those predictions were wrong was because their authors misdiagnosed the cause of low inflation at that time.

Price rises when either demand increases without a corresponding increase in supply, or supply falls without a corresponding decrease in demand. Inflation occurs when this mismatch between changes in demand and supply persists.

Throughout most of this century we have had a demand problem. Demographics changes has led to a rise in global savings. Globalisation has had a similar effect while simultaneously increasing supply. QE did not lead to inflation because it didn't change those dynamics.

People who argue that the current round of QE and government spending funded by borrowing at close to zero per cent will lead to inflation often overlook the above points. Once the Covid crisis draws to an end, there will be high unemployment and lots of spare capacity. High unemployment will mean weak demand, and it will take time for the problem to be fixed. Government stimulus can speed up recovery, with little inflationary risk, since there is plenty of spare capacity. Inflation may occur if stimulus is mistimed. 

The Great Demographic Reversal

The Great Demographic Reversal takes an altogether more nuanced view. It argues that those two forces that have created low inflation and record low-interest rates possibly are about to go into reverse.

I have a lot of time for this idea. There may well be something in it. Indeed, it is not a new theory. Back in 2013, economist Russell Napier made a similar argument.  

Right now, there is a high risk of a reversal in globalisation— and if this did happen, global output might well contract, and inflation and much higher interest rates may be the result.

As the baby boomer generation morphs from worrying about funding retirement to actual retirement, they will start living off savings — meaning they will be dissaving.  

These are big risks.

Why the theory may be wrong

I have two reasons to doubt. 

Firstly, the demographic shift is already advanced in Japan, where more than 20 per cent of the population are over 65. Yet, inflation is tiny in Japan. So the evidence from Japan does not support the demographic reversal argument.

Secondly, there is the role of technology and the lesson of the 1970s. Whenever people talk about the risk of inflation, they immediately remind us of what it was like in the 1970s. But the 1970s was a period of very low technology innovation. Before the 1970s, the western economies had boomed because they had worked out how to make use of the great innovations from the past, such as mass use of electricity, motor car, flight, telephone, etcetera. By the mid-1970s, all the low hanging fruit, created by previous innovations, had been picked. The economy was configured to benefit from rapid productivity growth, but this growth didn't occur. Therefore we got inflation and very high-interest rates. But right now, technology change is occurring super rapidly. Covid has accelerated the adoption of digital technologies. I make a similar argument in my new book: Living in the age of the jerk.

The main reason why I am so dubious about a return of inflation can thus be summed up by one word: technology. And if you want more detail: here are three words: rapidly changing technology. 

See also inflation is about as threatening as a puppy; should investors be celebrating? And does this justify the Green New Deal in the US?

A sneak preview of the future of bonds interest rates and inflation.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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