March 05, 2018

50 Years of Investment Management & Research

The Inflation Tide Is Ready to Turn

What You Need to Know

Inflation has been stubbornly low, leading many to question traditional gauges like the Phillips Curve. We think the theory still works—but doesn’t tell the full story. A more holistic assessment that includes structural influences shows inflation poised to rise.

Global Macro Perspectives

Investors face a key controversy in 2018: Why has inflation stayed so low when growth is

strong and unemployment is falling? That’s not how the world is meant to work, and it has raised

questions about the Phillips curve–a theory that links the rate of inflation (or wage growth) to

spare capacity in an economy. The theory is the foundation for modern central banking.

Some argue that the Phillips curve is no longer useful and should be abandoned. Others argue

that it’s still alive and well, ready to reassert itself as conditions permit (which could be quite

soon). A third group thinks central banks should stick to the Phillips curve even if doesn’t work,

because there’s nothing better right now. We don’t put much stock in this notion.

INFLATION DOESN’T SEEM VERY CYCLICAL TODAY

One thing that has become very clear in recent years is that we don’t understand inflation as

well as we thought. It’s certainly too complex to boil down to a simple concept like the Phillips

curve. But that doesn’t mean the Phillips curve doesn’t work—it just doesn’t tell the full story.

What else should investors look at to understand inflation? We think this requires both a

cyclical and structural perspective.

First, though, we need to get one important fact straight: in the context of the inflation-

targeting era, current inflation rates aren’t actually that low.

The best way to see this is by looking at the core inflation rate–inflation excluding food and

energy prices (

Display 1, page 2

). For major developed economies, core inflation is currently

1.4%. That’s pretty much the same as the average over the last 20 years (1.5%) and not much

below the average for the 10 years before the global financial crisis (1.6%). The picture is very

similar for headline inflation: it’s currently 1.9%, slightly higher than the 1998–2017 average

of 1.7% but the same as the precrisis average.

THE INFLATION TIDE

IS READY TO TURN

Inflation has been stubbornly low, leading many to question traditional gauges like the

Phillips curve. We think the theory still works—but doesn’t tell the full story. A more holistic

assessment that includes structural influences shows inflation poised to rise.

Darren Williams

Director

Global Economic Research

UNDERSTANDING

INFLATION REQUIRES

BOTH A CYCLICAL

AND STRUCTURAL

PERSPECTIVE.

Core inflation has also been remarkably stable over the last 20 years.

With two very brief exceptions, inflation excluding food and energy has

fluctuated in a narrow range between 1.0% and 2.0% since January

1998, and has been above 2.0% just once (at the peak of the last cycle

in August 2008). The lack of inflation volatility is all the more surprising

given the large swings in economic activity during that period. All told,

inflation hasn’t been very cyclical in recent years.

THE PHILLIPS CURVE ISN’T DEAD—BUT DOESN’T TELL

THE WHOLE STORY

Does this lack of cyclicality mean we should abandon the Phillips

curve? In our view, the answer is no. We think the theory behind the

curve still makes sense—at least as a partial explanation of inflation.

Most of the evidence still broadly supports the theory.

Display 2,

page 3

, compares annual developed-market core inflation to the

global output gap between 2000 and 2017 (

see

“The Phillips

Curve and Inflation,”

page 3

). There’s a clear positive relationship

between the size of the output gap and core inflation, which is

consistent with Phillips curve theory. The bigger the output gap,

the higher the rate of inflation.

But the relationship isn’t particularly strong, suggesting that other

factors are at play. And it takes a big change in the output gap to have

a material impact on core inflation; in other words, inflation isn’t that

responsive to business-cycle changes.

DISPLAY 1: TODAY’S INFLATION RATES AREN’T THAT LOW

G7 Consumer Price Inflation (Year-over-Year % Change)

Headline Inflation

Core Inflation

Implicit/Explicit

Inflation Target

1998–2017 Core-Inflation Average

Percent

–2

–1

Through November 30, 2017

Source: Haver Analytics and AllianceBernstein (AB)

THE INFLATION TIDE IS READY TO TURN

A cross-country analysis reinforces these findings, showing that

countries with large output gaps tend to have higher inflation than

countries with small output gaps. Moreover, the coefficient on the

output gap is small and has fallen, suggesting that inflation has

become less responsive to the business cycle.

In our view, the evidence continues to suggest that we should keep

the Phillips curve as an essential building block when it comes to

constructing a cyclical view of inflation. But it doesn’t provide a

complete picture. There’s a lot left unexplained—and that’s where

structural factors come in.

STRUCTURAL PRESSURES POISED TO REVIVE INFLATION

Unlike the debate over the Phillips curve, there’s little dispute about

the structural factors that have contributed to low inflation. It’s widely

accepted that globalization, technological change, demographics and

the debt overhang have all weighed on prices in recent years.

We think that’s starting to change, although not so much for

technology: the Internet, automation and robotics are likely to exert

downward pressure on prices for many years to come. But it’s

certainly true for other factors.

Demographics:

The ratio of working-age people to the total

population steadily increased in developed countries between

the 1960s and 2010 (

Display 3, page 4

). A growing labor pool put

downward pressure on inflation. However, we’re at a turning point:

the relative size of the working-age population is projected to fall very

sharply in the coming decades, reversing the impact from this factor

and putting upward pressure on inflation.

Globalization:

The forces of globalization have exacerbated

demographic trends. China’s 2001 entry into the World Trade

Organization, in particular, unleashed a huge pool of cheap labor

that helped hold inflation down. This won’t likely be repeated in

coming years: India and Africa may have the potential to replicate

China’s experience, but not anytime soon.

DISPLAY 2: INFLATION SEEMS LESS RESPONSIVE

TO BUSINESS CYCLE

Developed-Market Core Inflation vs. Global Output Gap (2000–2017)

Core Inflation (%)

Output Gap (%)

–4

–3

–2

–1

2.0

1.5

1.0

0.5

Core CPI = 1.64 + 0.13 Output Gap

As of December 31, 2017

Source: Bank of England, Haver Analytics and AB

THE PHILLIPS CURVE AND INFLATION

The Phillips curve is an economic theory that compares

an economy’s inflation rate to its unemployment rate. In

theory, as unemployment falls, wages and other prices

tend to increase.

The Phillips curve can also be used to compare inflation

with an economy’s output gap—the difference between

current economic output and potential economic output at

maximum efficiency, i.e., full employment. If an economy’s

current output is higher than its potential output, it is said

to have a positive output gap; under the Phillips curve, its

inflation rate should rise.

If current output is lower than potential output, an

economy is said to have a negative output gap, and

inflation should fall.

Populism:

Globalization has had a huge impact in moderating

inflation over the last 25 years, but it’s likely to give way to

populism over the next 25 years. There are three pillars to

the populist effect: raising the drawbridge (deglobalization),

institutional erosion, and greater redistribution of income and

wealth. In our view, all three of these pillars will ultimately result

in higher inflation (

Display 4

Debt Overhang:

Fiscal austerity and private-sector deleveraging

have weighed on demand since the global financial crisis, suppressing

inflation. But central-bank asset purchases and ultralow interest rates

have ended this process, allowing governments to abandon austerity

and allowing households and firms to postpone their deleveraging

efforts. We expect the debt overhang to put upward pressure on

prices, as higher inflation is ultimately seen as the most politically

expedient way of dealing with too much debt.

Each of these factors will play a part in determining inflation as

we move forward. But one additional factor is likely to be crucial,

particularly over longer time horizons: the monetary regime itself.

We think it’s worth exploring further.

DISPLAY 3: DEMOGRAPHIC INFLUENCE ON

INFLATION IS SET TO CHANGE

Working-Age Population as Percent of Total Developed-Market Population

Percent

2030F

2050F

2010

1990

1970

1950

As of June 21, 2017

Source: Haver Analytics, United Nations World Population Prospects—

Medium Variant and AB

DISPLAY 4: THE POPULIST EFFECT SHOULD PUSH INFLATION UP

RAISING THE DRAWBRIDGE

Increased trade protection

Restrictions on capital

flows and FDI

More restrictions on

immigration/cross-border

flows of labor

Withdrawal from supranational

relationships

INSTITUTIONAL EROSION

Erosion of monetary policy

independence—fiscal

dominance

Greater use of fiscal policy—

structural budget deficits;

loose constraints

Increased regulation

Renationalization of key

industries

REDISTRIBUTION

Increased taxation of

companies/high-income

earners

Higher minimum wages/labor

market regulation/universal

basic income

Return of collective bargaining

Use of price controls

As of January 18, 2018

Source: AB

Lower Growth

Higher Inflation

Greater Macro Volatility

Higher Inflation

Lower Profit Share

Higher Inflation

THE INFLATION TIDE IS READY TO TURN

A LIKELY SHIFT IN FUTURE MONETARY REGIME

It’s remarkable to note that only over the last century have countries

experienced the sustained inflation we now take for granted

(

Display 5

). But it’s no coincidence that this transition happened

at around the same time as the biggest monetary-regime shift in

history—moving from the gold standard to fiat (paper) money.

Likewise, the runaway inflation of the 1970s was tamed by another

major regime shift, one that prioritized low inflation and eventually

evolved into explicit inflation targeting.

We’re not recommending a return to the gold standard; far from it.

With high debt levels and rising populist pressures, we think it’s only a

matter of time before the current monetary regime is replaced by one

with more tolerance for high inflation rates.

This transition isn’t likely to take place overnight, particularly at the

global level. So how is the structural inflation backdrop likely to evolve

in the meantime? In

Display 6, page 6

, we offer a framework for

thinking about this over various time horizons.

When we look in the rearview mirror, the net impact of these

combined structural factors has been to put significant downward

pressure on inflation. This has contributed to the flatness of the

Phillips curve in recent years and made it hard for central banks to

reach their inflation targets.

But the structural inflation backdrop isn’t static, and downward

pressure on inflation has started to dissipate. Over the cyclical

horizon–the next six to 18 months–we expect structural factors

to have a broadly neutral impact on global inflation.

Further out, over the secular horizon, we think structural forces

will start to exert sustained upward pressure on inflation rates,

as the combined impact from the other factors begins to

outweigh the persistent downward pressure exerted by rapid

technological progress.

DISPLAY 5: MONETARY-REGIME CHOICE ULTIMATELY DRIVES INFLATION

Inflation Rate Indexed in Logarithmic Scale (1945 = 100)

Index

2000

1950

1900

1850

1800

120

150

180

Through December 31, 2016

Source: Bank of England, Haver Analytics, US Census Bureau and AB

SUMMING IT ALL UP

Our analysis suggests that it’s premature to abandon the Phillips

curve, and that it’s far too early to assume that inflation will remain

perpetually dormant. With structural and cyclical factors pointing in

the same direction, we think inflation is approaching a turning point

and set to rise.

This is likely to be a gradual process, at least over the cyclical

horizon—courtesy of a less responsive Phillips curve and the slow

nature of structural forces. But given current market pricing, which

in many cases is still set for deflation, even a hint of inflation would

leave central banks exposed and bond markets vulnerable.

The real story comes over the longer term: high debt levels and the

need to counter rising populist pressure will likely to lead to a more

inflationary monetary regime. Recent attempts to socialize higher

inflation targets and speculation about “helicopter” money are just

the first signs of a shift in this direction. We expect the inflation tide to

continue rising as structural pressures increase.

DISPLAY 6: STRUCTURAL FACTORS SET TO PUT UPWARD PRESSURE ON INFLATION

Rearview Mirror

Cyclical Horizon

Secular Horizon

Demographics

—

Globalization/Populism

—

Debt Overhang

—

Te chnolo g y

Monetary Regime

—

Net Impact

—

As of January 18, 2018

Source: AB

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