Many are surprised by the prolonged low inflation. It is hovering around 1.7%, which is less than half of pre-recession levels. This is somewhat unprecedented in modern US history. Inflation follows a predictable pattern. You get a recession, Federal Reserve starts lowering interest rates, economy picks up steam, unemployment rates fall and inflation picks up. This time is different. After several years of low rates and gradual growth in GDP, the inflation fails to turn up. First let us explore the causes of low inflation and then the reasoning behind my assertion that inflation will be muted for the next several years.
What is causing the low inflation?
- Slack in wages: This was Yellen's reasoning on why wage increase was low. When the recession started, employers didn't reduce the wages low enough. Now they have more slack and don't feel the pressure to raise wages. The labor force participation rate is also historically low at 62.8% when it historically averaged at 66% in last 30 years. As economy improves, those that are out of labor force will start looking for a job. The new entrants will continue to keep the lid on wages.
- Housing's Contribution to Gross Domestic Product (GDP) is 17.4%. About 40 percent of monthly consumer expenditures are housing related. Due to over buildup of houses during real estate bubble, fewer homes are being built. The construction spending as percentage of GDP is at 22% lower than 20 year lows.
Lower construction spending has resulted in lower construction jobs, lower demand for construction material and excess capacity.
- Capacity utilization remains lower than pre-recession levels. The productivity improvements in the economy due to just in time, information technology etc. has caused a long term drop in utilization.
- China has been a major source of inflation worldwide as it had a voracious appetite for commodities. The Chinese economic growth has slowed down significantly and inflation remains subdued.
The picture below was from Bill Gates' Tweet. The world has built a lot of capacity to accommodate a growing China. As China slows down, the demand for commodities has fallen. Many mines around the world are being shut down.
Oil has been another source of inflation. The peak oil theorists had a field day during the last commodity bubble. With the shale oil boom, oil prices keep falling. The trend is likely to continue for next several years. The productivity of existing shale oil wells are going up at triple digits.
Why will it remain muted for next several years?
The clue to this question is available in velocity of money. What is velocity of money? Here is the definition from the Federal Reserve website.
The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.
The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money. There are several components of the money supply,: M1, M2, and MZM (M3 is no longer tracked by the Federal Reserve); these components are arranged on a spectrum of narrowest to broadest. Consider M1, the narrowest component. M1 is the money supply of currency in circulation (notes and coins, traveler's checks [non-bank issuers], demand deposits, and checkable deposits). A decreasing velocity of M1 might indicate fewer short- term consumption transactions are taking place. We can think of shorter- term transactions as consumption we might make on an everyday basis.
The broader M2 component includes M1 in addition to saving deposits, certificates of deposit (less than $100,000), and money market deposits for individuals. Comparing the velocities of M1 and M2 provides some insight into how quickly the economy is spending and how quickly it is saving.
MZM (money with zero maturity) is the broadest component and consists of the supply of financial assets redeemable at par on demand: notes and coins in circulation, traveler's checks (non-bank issuers), demand deposits, other checkable deposits, savings deposits, and all money market funds. The velocity of MZM helps determine how often financial assets are switching hands within the economy.
As shown in the graph below, the MZM follows a pattern of bottoming out after recession, ascending and then starting a decline (when FED raises rates). The money velocity picks up when banks start lending and consumers start spending. The ultra-low money velocity is a symptom of a deep economic malaise. Increase in velocity of money indicates increase in aggregate demand and subsequent inflation. We don't see this pattern yet. If you look at the graph carefully, you'll notice that red line (CPI) lags the blue line (velocity) by 1 year.
What is the implication of low inflation?
The junk bonds, high dividend yielding stocks and medium term corporate bonds will continue to perform well. The broader stock market also will continue to perform well in near term (1-2 years).
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.