The inflation paradox

Some of the most renowned economic theories suggest that persistently low unemployment, strong economic growth and a very expansive money supply should feed through to inflationary pressures. But today's environment is very different, as a number of structural forces have muddied the economic waters.

Technology disrupters such as Amazon and Uber apply downward pressure on consumer prices and wages. This pressure is significant, as they tend to be large monopolies that are growing materially and, in the case of Amazon, are smashing down barriers to entry into new sectors.

The labour market has changed significantly, too. Organised labour, in terms of union membership, has been in decline since the mid-1980s, and there has also been a large pool of 'new' labour joining the world economy, for example when China joined the World Trade Organisation in 2001.

So, while employment might be high, the quality of many of these new jobs (think gig economy) is arguably lower and job insecurity higher - and so upwards pressure on wages is muted.

Finally, debt levels globally remain significant, despite the Great Financial Crisis occurring 10 years ago now, and this applies a constraint to end demand.

So, these powerful forces have disrupted relationships that held in previous environments. The impact of these forces hasn't been simplistic, or even one way, but there has been a general trend for an increase in the supply of goods and labour, and constrained end-demand.

This goes a long way to explaining why a decent cyclical upswing, with rates close to multi-year lows, has not been accompanied by roaring inflation.

The role of central banks has changed over time, too; the tools available to them have expanded and they have engaged in very unorthodox policy. Nevertheless, they still have explicit targets around consumer price inflation, often with a reference to broader objectives such as financial stability, economic growth and/or employment.

On these metrics, central banks seem to be doing fine. Consumer price inflation is generally below target and inflation expectations, whether measured by surveys or the break-even market, are subdued, while unemployment is low and growth is decent.

It certainly has been a sweet-spot for risk assets, evidenced by record highs in markets, the outperformance of emerging markets and credit spreads that continue to tighten.

So, what's not to like? In short, excesses are not exhibited solely in consumer prices. Central bankers' most recent psychological scarring will be the Great Financial Crisis, a crisis where financial excesses came to the fore in a benign inflationary environment.

In fact, it seems that central banks want to reduce the potential for the misallocation of capital, but are balancing that with avoiding asset price destruction and systemic risk.

Or, in other words, managing asset price inflation, rather than consumer price inflation. As a result, we think central banks are keen to raise rates opportunistically and understand much debate remains around the pace of any moves.

There are other points to consider, too. It's not in the current market narrative to consider what happens when (not if) this cyclical upswing turns and we get a downward shock.

A key risk is that deflation takes hold, with limited central bank firepower. Similarly, the markets seem unprepared for central banks unwinding their balance sheets, a move where history provides little help in terms of potential impacts.

In a nutshell, that economic theory has been turned on its head is largely irrelevant, and there are some good reasons for the inconsistencies.

We are generally sceptical as to the predictive insights models can provide, whether they are economic or risk-based. Things change and we believe forecasting is more about providing false comfort than accurate insight.

We prefer to identify the dominant themes and to try to understand what is driving them. So, for example, we have a material exposure to the technological disrupters mentioned earlier.

What does matter is that markets are currently underappreciating what happens when the cyclical upswing turns and when central banks start to remove, rather than add, liquidity.

This is possibly not for now but it's not to be ignored either. Ironically, it's exactly the type of complacency that central banks have been warning against.

Anthony Rayner is manager of Miton's multi-asset fund range.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.