The unprecedented monetary response to Covid-19 has sparked a storm of commentary in the financial media (and Twitter) about whether central bank actions will or won’t create inflation. In our view, in the absence of substantial shifts in political dynamics, these arguments are overblown and quantitative easing (and its various cousins) will not result in high inflation. Rather, our expectation is that inflation is likely to be disappointingly low over the next few years – which is a key risk for infrastructure investors, who are often significantly leveraged to inflation. However, before we dive into the reasons for our view, you first need to define what inflation you are talking about.
There are at least five types of inflation worth talking about:
· Consumer price inflation
· Commodity inflation
· Wage inflation
· Asset price inflation
· Exchange rate driven inflation
Consumer Price Inflation
This is the most common measure of inflation. Consumer prices reflect the prices of all goods and services in the household consumption basket. This includes both traded and non-traded goods. Traded goods are those where consumers have the option of buying imports (and local producers have the option of exporting). These will tend to move with exchange rates (and globalisation trends). Non-traded goods are those which don’t need to compete with imports, for example, dry cleaning (it’s not really practical to send your shirts to China to get cleaned). The biggest non-traded good/service in the CPI basket is housing (it is the largest single component of the CPI). Inflation for this component is based on movements in rents and construction costs (luckily Australian house prices don’t flow directly into the CPI).
Globalisation has tended to suppress tradeables prices over the past few decades (see below for cumulative tradeables vs non-tradeables inflation since 1999) – with average tradeables inflation 1.3% lower than the broader CPI. This highlights the suppressing impact of globalisation, and in particular, cheap imports have had on Australian inflation. Similar experiences apply in other developed countries.
Looking ahead – to the extent that one of the consequences of Covid-19 (and the pre-existing geopolitical tensions between the US and China) – is a reversal of globalisation, this would be expected to feed through as a moderate increase in inflation.
Commodity price inflation
This is a specific form of inflation where increases in raw inputs into production drive up the overall price level. This is usually pretty rare – with some input prices rising sharply but offset by falls in other costs. A classic example of commodity price inflation affecting the broad inflation rate is the oil price shock of the 1970s.
Labour is the most important input into the production of virtually all goods and services. High wage rises lead to cost-push driven increases in the prices of goods and services. This can lead to a feedback loop where wages increases drive broader consumer price inflation that feeds back into higher wage increases. Inflation in the 1970s was partly a function of oil price shock driven inflation feeding into wages and creating sustained high inflation (rather than just a one-off jump in the price level).
It is very difficult to get sustained inflation without wage inflation. In today’s context, intuitively the very high level of unemployment, which will take years to absorb, should keep a lid on wages and, hence, wage inflation seems unlikely in the short term.
This is a key reason why we think high inflation is unlikely to be a problem in the medium term.
The only caveat to this is that Covid-19 has shone a light on inequality. A key driver of inequality is the unusually low labour share of GDP. One possible fix for inequality would be a substantial increase in wages (perhaps as an outcome of the Gilets Jaunes movement or other populist agenda). With the current high level of unemployment, higher wages seem implausible, but when thinking about inflation on a long-term basis, we think it is important to be cognisant of this long-term imbalance (and as Stein’s Law says, what is unsustainable, must eventually stop).
There are a range of ways these problems could be resolved (and the best bet is that the can will be kicked down the road as far as possible) but resolution of these issues, particularly through Modern Monetary Theory type approaches or Universal Basic Income could be inflationary.
Asset price inflation
Asset price inflation is an increase in the prices of assets (shares/land/houses) rather than consumer goods. There is some link with consumer prices because factories or houses needed to be built and physical cost of construction is a driver. However, many of these assets aren’t built (e.g. land) and are predominantly financial assets traded on the secondary market.
Low interest rates (particularly low real interest rates) drive high asset values. This leads to the paradox that Australian wages have grown strongly, in terms of their capacity to buy consumer goods as measured by the CPI over past 50 years, but if you look at those same wages in terms of their capacity to buy a house (i.e. how many years’ salary are house prices) then wage growth has been abysmal.
While there has been much debate about the effectiveness of QE in terms of stimulating sustained economic growth or consumer price inflation, there is much less debate that QE and central bank policy has been a key driver of asset price inflation over the past decade. Given the circumstances and experience of the last decade, this seems likely to continue to be a significant influence on asset prices over the period ahead.
Exchange rate driven inflation
This is only relevant in the context of a single country, as exchange rates only affect relative prices between countries. A currency collapse is almost always associated with an inflationary episode. That is, the fall in exchange rate drives up the price of imports (and also drives up the prices of goods that could otherwise be exported). This results in an inflationary episode (think Argentina in 2001/2002 or Turkey in 2018). These events often can be associated with a country being unable to service its foreign debts and suffering a crushing recession (often as interest rates initially go sky high in an attempt to defend the currency).
This is a local phenomenon for the country affected by high inflation (and this usually passes after a year or two as the resulting recession crushes economic activity) and the rest of the world has slightly lower inflation (as cheap exports from the affected country push down prices).
This is a zero‑sum game and can’t apply on a whole of world basis. While individual countries can use QE/monetary policy in an attempt to drive down their exchange rate (yes I am talking about you New Zealand) it isn’t possible for every country in the world to have a falling exchange rate (i.e. the often talked about ‘race for the bottom’).
Monetary policy and inflation
Monetary policy, and market participants’ expectations about monetary policy, are a key driver of long-term inflation outcomes. For example, in Australia the RBA targets 2-3% inflation over the course of cycle. If inflation is running below this, they will tend to cut rates (or keep real rates low) and if inflation looks like it will go above the 2-3% range, then RBA will tend to raise rates. This framework – particularly if the central bank has creditability and acts independently – anchors inflation. That is, wage negotiations are based on assumption that inflation target is achieved (and hence, wage outcomes tend to be internally consistent with the inflation target).
The RBA target is 2-3% over the cycle and average inflation over the period since 1999 has been 2.6%. That is, inflation targeting has largely worked – with market participants treating the inflation target as a creditable regime over the past 30 years or so.
Don’t Governments want to inflate their debts away?
Often in discussions about long-term inflation trends one the arguments raised is that governments around the world have large and growing government debt levels and that they will seek to inflate away their debt. Japan is the poster child for this, but the US and much of Europe has seen a step change in government indebtedness post the GFC.
The argument is that for governments with high debt levels there is an incentive for governments to run a higher inflation level and deflate their debt away. The reality is not that easy:
· Higher inflation would feed through into higher interest rates on new government borrowing (and most government borrowing is being rolled/refinanced pretty frequently) and so while a spike in inflation might help in the short term, but unless interest rates can be suppressed, in the longer term higher inflation will feed through to higher interest rates on government debt and, hence, doesn’t help the net position.
· It is important to remember that the central bank is just an arm of government. Thus, QE isn’t a new source of funding for governments. QE is swapping government bonds (ie long-term debt) for bank reserves with the central bank (effectively short term debt). The effect of QE is to lower the net duration of government borrowing. Thus, QE actually makes it harder to inflate debt away because government borrowing costs become more sensitive to short-term interest rates.
· Even if governments had a financial incentive to pursue higher inflation, they face political constraints as well. In particular, high inflation is politically unpopular. High inflation would be hugely unpopular amongst those on fixed income (namely retirees) as inflation undermines the value of their savings and they wouldn’t get an offsetting benefit through higher wages. In this context, Japan is instructive. Japan has massive government debt and has been pursuing unconventional monetary policy for two decades. If inflating government debt away is the “end game” of QE why haven’t they done it already?
In conclusion, we are of the view that QE doesn’t necessarily produce consumer price inflation and that governments with high debt levels won’t necessarily use QE and inflation to inflate away their debts.
Rather a better characterisation of the operation of monetary policy over the past decade or so, is that QE and other low/zero/negative interest rate policies have been deployed in the face of economic shocks and shortfalls in demand. The objective of these policies has been to stimulate demand (by using low rates to bring forward consumer and investment demand) to fill in the demand “hole”. Almost by definition, this brought forward demand is smaller than the demand shortfall that policy makers were trying to fix and, hence, did not result in an aggregate increase in demand and, hence, did not create inflation.
Under this thought process, unconventional monetary policy and QE is a response to underlying deflationary pressures and cannot, on its own, produce outright inflation.
To get outright inflation you need either more money/demand chasing limited supply (for example, deficit government spending that exceeds the slack in the economy or outright money printing) or fundamental changes in wage setting arrangements (for example, universal basic income or a complete reset in wage negotiation arrangements in response to concerns about inequality).
In the absence of these radical changes, QE is a response to deflation and in many ways perpetuates a deflationary environment as the bring forward of investment/consumer demand through QE creates ongoing excess capacity and over indebtedness (both of which are deflationary). This indebtedness is a drag on future consumption (more and more income is allocated to debt service than consumption) and thus the cycle continues.
Infradebt Inflation Outlook
It is important to be clear about time horizon:
· Short (3-12 months). Covid-19 supply bottlenecks mean there could actually result in price inflation – particularly for necessities whose supply chains are disrupted by Covid-19. A classic example is food.
· Medium-term (next 3-5 years). We expect below average inflation. There is likely to be substantial sustained unemployment across the world as well as excess capacity. We would expect continued low wage growth. This is an environment of low inflation/deflation. The only countervailing force is deglobalisation, but expect this to be more than offset by resource slack. Our view is consistent with bond market pricing – where implied inflation over next 5 years is circa 0.5% per annum – well below the typical 2.5% infrastructure financial model assumption.
· Long-term. Fundamentally uncertain. Will depend on if, or how, current imbalances are resolved. One scenario is a world much the same as last 20-30 years (and inflation remains relatively low). Another scenario, for example if MMT or UBI policies were broadly implemented, if that resolution ultimately does involve high inflation (as part of clearing out excess debt but also to reset the labour share of GDP and address inequality). If you think this through though, it requires huge political change from the status quo of today and of the last 40 years – it won’t happen without you knowing about it!.
Inflation is Key for Infrastructure Investors
Inflation is a very important return driver for many infrastructure investments. In particular, infrastructure equity returns are usually highly leveraged to inflation. This arises because revenues are often CPI linked, but debt is structured on a nominal basis. This means equity often is 2-3x levered to inflation.
In this context, it is worth noting that many investors adopt internally inconsistent positions. That is, they forecast project revenues on the basis of a relatively high inflation forecast (2.5% is the most common assumption we see) but then use market forward curves to forecast the cost of debt. Given that current market interest rates are between 0% and 1% depending on your horizon, the interest rate market thinks inflation is going to be much less than 2.5% on a long-term basis.
For infrastructure investors the short term is just noise. The key issues are both the medium term and long-term outlook for inflation.
Our view of the medium term is that inflation is likely to be relatively weak and this will be a headwind for infrastructure projects.
Longer term there is significant uncertainty and a key attractive feature for infrastructure projects is that they provide a hedge against future inflation. In particular, compared to equities, infrastructure projects tend to have higher operating margins and much lower labour costs, thus in a scenario where inflation is high and a key driver of this is higher labour costs, infrastructure should outperform equities.