Global inflation: Have deflationary forces subsided?

While proving more persistent than many were expecting, global inflation finally appears to be on a downward trend and – barring some unforeseen events – should continue to ease over the next 12 months or so.

However, the longer-term outlook is much less certain and is likely to once again be dictated by a number of structural forces. While we would expect technology to continue to act as a powerful deflationary force, we think the impact of globalisation could start to recede over the coming years as countries adapt to the new world order. Longer-term demographic changes will also be a key factor to consider as the global economy contends with an ageing population and tighter labour markets.

“While we would expect technology to continue to act as a powerful deflationary force, the impact of globalisation could start to recede.”
 

Inflation has been the dominant theme in financial markets, leading to a seismic shift in central bank policy and a significant re-pricing across financial assets. Between March 2022 and May 2023, the Federal Reserve (Fed) announced 10 consecutive rate hikes as it sought to rein in surging prices. The world’s other major central banks largely followed the same path, bringing the era of ultra-low interest rates to an abrupt end.

While inflation has perhaps proved stickier than many were expecting, things do now finally appear to be on the right path. This is certainly the case in the US, where the annual change in the Consumer Price Index (CPI) has fallen from a peak of 9.1% in June 2022 to just 3% by June 2023. Furthermore, it is no longer just a few items that are pushing overall inflation lower, but a broader trend as evidenced by the recent fall in median CPI.

A large part of the recent dip in headline CPI has been driven by lower energy and freight costs, as well as so-called ‘base effects’, whereby earlier price spikes start to fall out of the year-on-year inflation calculation. While the labour market remains tight, so far we are seeing little sign of any wage-price spiral. The deceleration in rents is another encouraging sign given that this represents the biggest component of US inflation.

Looking ahead, we would point to the sharp drop in US money supply – falling money supply is typically associated with lower inflation over the subsequent 18 months, as the chart shows. Recent money supply trends suggest that US inflation could continue its recent downward trend over the next year or so. While it’s probably too soon to be declaring victory just yet – and of course one can never discount completely unforeseen events – as things stand it does look like the current US interest rate hiking cycle could be reaching its conclusion.

Structural forces

While easing inflation should take some pressure off central banks and be good news for bond investors, getting inflation back to the Fed’s 2% target could prove more difficult, at least on a sustained basis. In the near-term, a tight labour market and rapid wage growth is likely to provide an ongoing source of inflationary pressure, which could largely offset the impact of lower goods and commodity prices.

However, looking beyond the next couple of years, the path of inflation is likely once again to be driven by a number of longer-term structural forces. Until the recent blip, inflation had been on a sustained downward trend for a number of decades. There were several forces at play here, although we would highlight three as being particularly significant: globalisation, technological advancement and demographic change.

Inflation returned with a vengeance in the second half of 2021 as the post-pandemic re-opening of the global economy created epic supply-chain disruptions. This was perhaps best symbolised by images of the container ship stuck in the Suez canal for six days in 2021. If this wasn’t enough, the global economy then had to contend with the spike in energy prices following the Russian invasion of Ukraine at the start of 2022. By the middle of the year, headline inflation in the Euro area and the UK had reached double-digit levels, a phenomenon not seen since the early 1980s.

Have we reached peak globalisation?

The key question investors need to consider now is the extent to which the longer term deflationary forces highlighted above will reassert themselves, or if their impact will start to diminish and the recent surge in prices prove to be longer lasting.

Globalisation – the rapid increase in global trade over the past three decades has been a major factor that has helped drive inflation down. Through the opening up of global markets, consumers and businesses have been able to enjoy cheap imports from countries with lower production costs. Outsourcing and offshoring has been another important factor, allowing companies to move their operations to countries with lower labour or production costs.

Of the three deflationary forces highlighted here, globalisation is perhaps the one that could recede the most in importance going forward. The past couple of years have seen an increasing number of companies looking to onshore their production in order to reduce the risk of supply chain disruptions – this will inevitably lead to higher costs.

We are also seeing the increased use of tariffs and other restrictive trade measures, amid rising trade tensions between the US and China and through issues such as Brexit. While globalisation will probably continue to be a deflationary force overall, its impact is likely to be less powerful than it has been over the past few decades.

Technological advancement – through increased efficiency and a raft of productivity improvements, technology has also played a key role in keeping inflation low. Automation, robotics and digitalisation have helped create more efficient production processes, enabling firms to produce goods and services at much lower costs. Alongside, this, we would also highlight the impact of e-commerce and online marketplaces, which have fostered greater price discovery for consumers, as well as increased competition between firms.

In our view, technology will continue to play an important role in keeping inflation low. Rapid advancements in Artificial Intelligence (AI), in particular, are likely to be an important deflationary force for the foreseeable future, helping firms to further optimise their processes and streamline their operations. The pace of technological advancement shows little sign of slowing and this should be good news for long-term inflation trends.

Demographic change – demographics can also have a significant impact on inflation, with changes in the make-up of the population heavily influencing both the supply and demand of labour, goods and services. Ageing populations, in particular, can lead to labour shortages as the number of working age workers declines relative to the elderly. This, in turn, should leave workers in a better position to push for higher wages, which could lead to upward pressure on inflation. At the same time, an increase in the elderly population could lead to a higher demand for health and social care, potentially pushing up costs in those areas.

Long-term influencers

While proving more persistent than many were expecting, global inflation finally appears to be on a downward trend and – barring some unforeseen events – should continue to ease over the next 12 months or so.

However, the longer-term outlook is much less certain and is likely to once again be dictated by a number of structural forces. While we would expect technology to continue to act as a powerful deflationary force, we think the impact of globalisation could start to recede over the coming years as countries adapt to the new world order. Longer-term demographic changes will also be a key factors to consider as the global economy contends with an ageing population and tighter labour markets.

This article was first published in the inaugural edition of our bi-annual thought leadership magazine Ampersand as “Deflationary forces: Defeated they are?”. 

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.